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When To Dump A Stock

Brokerage houses make A living telling people which stocks they should buy. Selling, however, is a whole other matter. With little guidance from brokers--much less business magazines--investors tend to hang on to broken stocks much the same way a jilted lover keeps playing an old mix tape.

It's not easy for an investor to turn the page, but developing sell discipline is essential. "It's about removing the emotion," says Don Kukla, a principal at St. Louis financial planners Moneta Group LLC. "You need to appeal to logic to overcome that emotion."

Logic backed by a little bit of knowledge, that is. There are four telltale signs that it's time to sell a stock--any stock, regardless of its onetime appeal. Investors who follow these strictures can greatly limit their investing heartbreak.

Start with traditional fundamentals: revenue, earnings, and all the multiples and ratios that go with them. There's just no ignoring them. The fact that General Motors Corp. (GM) shares have recently doubled--albeit from a 24-year low--might convince investors that it's back in the high life. The company says it's continuing this momentum by slashing its crippling structural costs. GM's auto operations posted an adjusted net loss of $116 million in the latest quarter--no cause for celebration, but a $1.5 billion improvement over last year. And the company seems ready to invest in innovation, with management having just announced plans to make GM the first automaker to commit to producing a plug-in hybrid car.

But that doesn't change the fact that GM remains a financial basket case. For all its cost-cutting progress, IT is still rapidly burning through cash, essentially drawing down on its savings to pay its current bills. Lackluster vehicle sales and continued market share losses to Toyota Motor Corp. (TM) contributed to GM's negative free cash flow of $5 billion in the latest quarter. That stat should dampen most of the enthusiasm for the company's shrinking $20.4 billion cash balance. (GM's more than $30 billion in debt should dampen the rest.)

"IT'S A STORY OF massive pension and union costs, huge competition, and declining market share," says Pat Dorsey, director of stock analysis at Chicago-based investment research firm Morningstar Inc. (MORN). "It's an awful business that is overvalued." Even worse, he says, shareholders will be the very last to get their hands on any profit the company might eke out. "Are you really going to tell me that the unions and retirees aren't going to try to grab it?" he asks, noting that GM's pension and benefit liabilities eclipse its equity value. The stock traded recently at $30. "Get out," says Dorsey. "It's worth $15." Another cue: Billionaire Kirk Kerkorian, the activist investor who used his 10% GM position to agitate for the cost cuts that boosted the stock, just dumped the last of his shares.

Rule No. 2: Always examine nontraditional valuation readings. Ivan Feinseth of Matrix Investment Research uses return-on-capital measures to spot problems, an approach that has helped him trounce the market the past two years. Definitions differ; Feinseth considers return on capital to be a company's net operating profit after taxes, divided by capital. It shows how well a company uses shareholder money.

Consider outdoor retailer Cabela's Inc. (CAB). Between 2003 and 2006, the company boosted sales by 36% and profits by 46%. The problem: Cabela's is spending so much to expand its store count that it has cut its return on capital in half during the past three years. "On the surface," he says, "Cabela's growth story is powerful. But peel back a layer and you'll realize they are not making shareholders real money." Feinseth calculates that Cabela's "economic value added"--the amount by which its earnings exceed or fall short of the minimum rate of return that shareholders could have received elsewhere--has fallen from $43 million in 2003 to -$16 million today. The new stores, he says, are churning out diminishing returns for shareholders. "They would have to tremendously increase profit margins just to fit into all their new overhead," he says. Feinseth worries, too, about the company's plans to open more stores in the next 12 months than it has in the past two years, despite the fact that its most profitable sales come from catalog and Internet operations. With shares near a 52-week high, Feinseth urges investors to bail.

It's also important to pay attention to what bond analysts are saying. After all, bondholders are their target audience--and these creditors get priority over shareholders if a company has to liquidate its assets. Credit analysts are keenly alert to cash-flow and balance sheet trends that very often ripple into a company's stock price. "You can play with earnings," says analyst Shelly Lombard of Gimme Credit LLC, a New York capital structure research firm. "But things like operating cash flow and the balance sheet generally don't lie."

LOMBARD THINKS shareholders of auto parts maker American Axle & Manufacturing Inc. (AXL) should heed her warning that the company is an "ax-cident waiting to happen." In October, Axle, a major GM supplier, posted its first quarterly loss in its seven-year history as a publicly traded company. Even as sales and production volume have plunged, shareholders have kept the stock afloat largely on hopes of improved cost-cutting and a sustained GM turnaround. Lombard thinks they are overlooking the fact that Axle is living on borrowed time, drawing from a $600 million revolving credit line just to make ends meet. Its net operating cash flow of -$25.5 million in the latest quarter plunged from $8.6 million last year. "It's not a sustainable capital structure," Lombard says. "Eventually the cash is going to run out." If that happens, her bondholding clients will still get a piece of the remaining assets. Shareholders likely won't.

Last, investors should always think like contrarians. Wall Street analysts tend to act in unison, upgrading stocks en masse after good news and downgrading after shares have already fallen. Having a contrarian sell discipline--trimming while they are promoting--lets you cash out into strength.

Todd Salamone of Schaeffer's Investment Research Inc. suggests going against the resurgence of bullishness for Microsoft Corp (MSFT), whose shares have soared 37% since June. In May, Salamone says, 53% of analysts who covered Microsoft were recommending it; that figure is now up to 70%. Salamone thinks back to 2004, when there was near-unanimous bullishness for Microsoft. The stock would ultimately lose more than 2% for the year while the NASDAQ gained nearly 9%. "A lot of hope is being built into the stock again," he says, "and you wouldn't want to buy high expectations." Salamone says the optimism surrounding the release of Microsoft's Vista operating system is overrated and, in any event, it's already reflected in the share price.

The company, once a highflier, remains mired in a prolonged, often fitful markdown of its earnings multiple, as investors come to terms with a more sedentary Microsoft. Salamone says his bearishness is also buttressed by Microsoft's unusually low amount of short-selling activity. Short-sellers bet that the share price will go down. Right now, just 2.5 times the average daily volume is represented by so-called short interest. That's down sharply from its 2004 peak of 3.8 times and a full point lower than NASDAQ's current short interest ratio. That tells Salamone there just isn't enough skepticism toward the stock. He would rather unload Microsoft shares now than wait until a change in sentiment marks them lower. "You have to be careful about getting into one-directional bullishness," he says. "The more people in a room, the more need to head for the exits."

By Roben Farzad

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