An old Wall Street adage says to never get "married" to a stock. No matter how much you may love it, when the outlook changes you must be ready to sell it. It is only a piece of paper, after all.
Naturally, the challenge is being able to identify which of your names are getting stale, and to sell them before they blow up on you.
For myself, I use changes in the earnings-estimate revision trend to identify my sell candidates. A change in revision trend alone does not guarantee that fundamentals have changed for a stock, but it is as good a distant early-warning system as you can find.
A recent example is Seagate Technology (STX). I loved Seagate six months ago. At that point, the disk drive industry had had its capacity knocked out due to the tragic Thai floods, so pricing was firm and market share could shift. (Seagate was less affected than were other drive makers.) Seagate was blowing away estimates, yet trading at a low single-digit price-to-earnings ratio with a dividend yield of more than 5%. In fact, last November I highlighted the drive stocks, including Seagate, as the "Unsung Heroes of the Information Age."
Seagate was my best-performing holding through most of the first half of 2012: It started the year at $16 and ran all the way to $32 before cracking in this spring's correction and settling in the mid-$20s. How can you not love a stock like that?
Well, I blew it out a few weeks ago when the estimate revision trend turned decidedly average. Analysts were no longer sharply raising estimates, and even though they were not yet cutting them aggressively, once a stock is simply "average," I move on. Why wait for things to get bad? I want to own stocks for which the situation is improving. As much as I loved Seagate, I followed my discipline and sold it.
Lo and behold, on July 5 Seagate warned that it would miss revenue expectations by 10% and that gross margin would be 100 basis points below plan. The company noted that market share gains had ended as other vendors hurt by the Thai floods recovered more quickly than anticipated. The company also cited soft economic conditions as adding caution to its outlook. Real Money's own Chris Laudani penned an excellent summary of the miss .
My point in this long story is not to take a victory lap, but to point out the importance of having a set of early-warning indicators, and to follow your discipline and sell even when your emotions may argue otherwise. A significant deterioration in the estimate-revision trend is an excellent early-warning system.
Below is a table showing all the stocks with strong upward-revision trends that reversed during the quarter. A "1" in the revision rank means the name was among those with the strongest upward trends. A "10" is the worst decile group. At the top of the table, you can see those names that were looking great at the start of the quarter, but have sunk to being dogs. If they haven't warned already, there is a very high probability that they will report soft results or offer poor forward guidance. These names should be avoided on the long side, even if the multiple is dirt-cheap. The cheap ones are classic examples of a value trap.
(The names at the bottom of the table, which have maintained their earnings momentum, are solid long candidates. With those, you simply have to be more careful about valuation, as some are in nosebleed territory. For instance, I like Discover (DFS), which has great earnings momentum and is cheap at only a 9x P/E.)
Study the table, and if you are long names at the top, seriously consider selling them and moving on to greener pastures.