When to Sell Stocks:When Growth Stocks Go Bad

By Mike Cintolo, Vice President of investments and Chief Analyst, Cabot Growth Investor and Cabot Top Ten Trader
From Cabot Growth Investor

We love growth stocks. Throughout the years, we've uncovered dozens that have doubled or more (in some instances, much more) in a relatively short period of time; some of these winners literally made our entire years, helping lead the Cabot Market Letter Model Portfolio to terrific gains.

But no matter how good a stock has been to you, it's vital to remember one absolute truth—all leading stocks are going to top. Most investors fall into the trap of thinking that, because earnings are cruising higher and the story remains good, their stock is insulated from forming a long-lasting top. That is not the case.

In fact, it's just the opposite. Bill O'Neil of Investor's Business Daily has written that, once a big leading stock tops, its average decline to its final bottom is 72%!  In our decades of growth investing experience we've seen it happen time and again; when a growth stock goes bad, it really hits the skids. That's why it's vital for you to heed a stock's message, and never fall in love. You need to know when to sell your stocks.

Crocs (CROX) was one of our favorite names in 2007, and we made great money in the stock until a "disappointing" third-quarter earnings report (earnings were up "only" 144%) crushed the shares. Despite further good news last week (fourth quarter earnings were reported up 73%), the stock now sits 66% off its all-time peak. All in less than four months!

XM Satellite Radio (XMSR) was our first big winner of the 2003 bull market; it rose from our purchase price of 5 in March 2003 to a peak of 41 by the end of 2004. Even in October 2005, the stock was still standing in the mid 30s.  But when the tide turned, XMSR collapsed, sliding persistently until it fell below 10 in July 2007—a 74% haircut in less than two years. Note, by the way, that even after that decline got underway, XM was still growing fast; revenue growth, while decelerating, remained in the triple digits through the first quarter of 2006.

eResearch (ERES) was another winner from the 2003 time period. After we bought at a split-adjusted 6 3/4 in April 2003, the stock zoomed to 22 by October and hit a peak of 30 in July 2004. At the top, sales and earnings were up 91% and 200%, respectively, but that didn't prevent the stock from dropping a ridiculous 63% over the next three months! ERES eventually fell below 6 in 2006, down 80% from its all-time peak.

On the way up, all of these companies had great stories with big sales and earnings growth that propelled their stocks higher.  And, importantly, they all continued to have great stories and growth numbers for months after they topped. Translation:  If you're holding on to a former winner because "it's a great company, and business is still good," you need to find another reason. You need to know when to sell the stock.

Why do these drops happen? Because the stocks become over-owned; after a year or two of advancing at a great clip, and with many great quarterly reports under their belts, the stocks have been bought by hundreds of mutual, pension and hedge funds. At some point, no matter how good a firm's growth, some of these institutions decide when to sell stocks or trim their position, which can top out the stock. And remember, these funds take a long time to build and unload positions, so when the top is in, it takes months before the selling subsides.

Plus, it doesn't have to be a small, revolutionary company to be taken down; from our initial market buy signal in March 2003, eBay (EBAY) rose 180% over the next twenty months, while Yahoo! (YHOO) rose 240% during the same time frame. But once the funds started to bail, EBAY lost more than 60% while YHOO was chopped in half…even as sales and earnings growth remained positive.

We're not writing this to scare you or depress you; too many investors look at the selling of a big growth stock as a sad cutting of ties, an action that kills any hope that they'll make more money from the stock. Really, though, it's just part of the process—just as in any sport, sometimes it's time for defense, other times, offense. Knowing when to sell stocks is part of the game.

There's one final reason to be on guard with former leaders: When a new bull market begins, there will be dozens of great growth investing opportunities…but only if you're not tied up (both monetarily and emotionally) with the old leaders! Thus, it's best to have room in your portfolio for new and potentially huge winners (maybe some that are already in the Cabot Market Letter Model Portfolio) when the tide turns back up.

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