Holding Stocks: You've Bought a Stock--Now What?

Red Flags To Watch For

Don't assume your stock will always be a great stock. You need to watch a number of key fundamentals (The financial characteristics of a company, such as earnings and sales.) for signs of trouble:

 

• EARNINGS GROWTH: Is earnings growth slipping compared to other companies? Or has the company's earnings growth decelerated sharply in the two latest quarters? (for example, if earnings growth has been about 100% for several quarters and it slows down to 25% in one quarter and then to 20%.)

You can check the earnings situation of a stock in Investor's Business Daily's stock tables. Consider it a red flag if the Earnings Per Share (EPS) Rating, a part of IBD SmartSelect® Corporate Ratings, falls below 70. Generally, you should buy established growth stocks with an EPS Rating of 80 or higher.

What about some technology stocks with no earnings but huge sales growth? These stocks scored some of the biggest gains in the five months starting October 1999. In these cases, powerful sales growth is usually the driving factor. By the same token, a sharp drop in sales growth could signal a slowdown.

• PRICE STRENGTH: Is the stock losing ground relative to the rest of the market? Consider it a red flag if the Relative Price Strength Rating falls below 70, or drops sharply. Preferably, your stock should have a rating of at least 80 to maintain its leadership, and preferably 90 or higher.
   
• INDUSTRY LEADERSHIP: Is your stock in an industry group in which the majority of leaders are falling amid heavy volume? In this situation, the other stocks in the industry will likely be vulnerable to a sell-off. As much as half of a stock's move is tied to its industry and sector. IBD's Industry Group Relative Strength Rating shows how well the stock's industry group is performing compared to 196 other groups. The rating should be "A" or "B," meaning the top 40% of industries. Most stocks in "D" and "E" rated groups should be avoided.
   
• FINANCIALS: Are sales, profit margins or return on equity faltering? You can check these vital yardsticks of financial performance with the Sales+Profit Margins+ROE Rating of IBD SmartSelect™ Corporate Ratings. The "A" rating represents the top 20% of stocks. The "B" rating is for the next 20% tier of top companies. Generally, you'd want to see stocks with an "A" or "B" rating. But some high-flying technology and biotechnology stocks with groundbreaking products have ratings of "C" or "D." That's because they haven't turned a profit yet, and consequently have zero margins and return on equity. What you really need to watch for is the direction of the rating. For example, you don't want to see a stock going from "C" to "D" or from "B" to "E."
   
• SPONSORSHIP: Is the stock losing favor among mutual funds and other professional investors? Funds represent the lion's share of trading activity, so their buying and selling decisions greatly influence stock prices. IBD's Accumulation/Distribution Rating weighs the amount of buying vs. selling. You want a stock that's under big demand and is rated A (the stock is being heavily bought) or B (seeing moderate buying). Be wary if the rating falls to D (moderate selling) or E (heavy selling).

Here are a number of technical characteristics to watch for with the aid of stock charts. (The lesson titled "Using Stock Charts To Round Out Stock Selection" has a full description of chart patterns and buy points.)

• FAILED BREAKOUTS: Your stock has been moving sideways (in a consolidation phase) for a number of weeks. It finally moves higher, but only slightly, then reverses direction and declines on heavy volume for several days. Once the stock has retreated to 5% below the buy, or "pivot," point, it's time to consider selling.

• VOLUME SPIKES: You own a stock that's had a long advance. Then one day it closes lower as trading volume hits the highest level since the beginning of the advance. When volume surges like this, it marks a pivotal vote by professional investors. If the stock closes lower, it could be a warning that the pros are souring on the stock and more price declines are in store.
   

• MOVING AVERAGE: Be wary if your stock closes several weeks in a row below its 50-day moving average, unable to rally. (The moving average is a line that plots the average price over the past 50 trading days. It smoothes out the daily price fluctuations to provide a better look at the stock's overall trend.) The moving average often serves as a "support" level for the stock price. If it falls below the line for a time, it could mean support has eroded.

• STOCK SPLITS: Your stock splits a second time in less than 12 months. (Stock splits are when a company increases its shares outstanding and the share price is adjusted accordingly. Example: XYZ Corp. sets a 2-for-1 split of 100 million shares trading at $50 each. After the split, there are 200 million shares trading at $25.) This could tilt the supply-demand equation because there's a bigger supply of shares to go around. Daily Graphs® chart service provides information on stock splits, and some are noted in IBD's editorial pages.
   
• CLUES FROM HEAVY VOLUME: After a substantial advance, trading volume increases but your stock price doesn't move up much for several days. This is called churning, and it means the stock is having difficulty making further gains even though buying activity is high. Also potentially harmful is when a stock falls in price on heavy volume.

• GAP UPS: A stock that has been climbing for several months, and is very extended percentagewise in price, then opens trading higher than its highest price traded for the day before. This is called a "gap up." If a stock's gap is unusually large, perhaps it should be sold.

• PROFESSIONAL INVESTORS: Mutual funds and other professional investors start selling the stock. This would show up as a drop in the Accumulation/Distribution Rating to C or lower. A sign that top-performing funds are moving out of a stock is when the Sponsorship Rating falls to C or lower. You can check individual funds' recent sells in IBD's Making Money In Mutuals section.

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