Rule Breaker Mailbag: When Should I Sell a Plunging Rule-Breaker

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In this segment from the Rule Breaker Investing podcast, David Gardner answers a question that nearly every investor will face at some point: How do I know when to sell? His querier has a small-cap Rule Breaker stock that has taken a turn for the worse, price wise. What he's unclear about is whether the impetus for its dive is short- or long-term problem, and he's in need of guidance on how what in the conference calls and earnings reports might tell him if it's time to cut his loses. Gardner has a couple of thoughts on the matter.

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A full transcript follows the video.

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This video was recorded on Nov. 29, 2017.

David Gardner: Mailbag Item No. 3: This one comes from Mike Strain writing from Claremore, Okla. I always enjoy it when people include where they're writing from so thanks, Mike.

Mike says, "I started listening about a year ago. Really enjoy the podcast. Great mix of investing insight, interviews, and practical information. Love the series on great company culture." Thank you, Mike! Thanks for all of it.

"Now onto my question. I own shares of a Rule Breaker that had a 34% drop in one day last week." I'll just insert "Ouch!"

"I expect volatility with small companies and that painful drop seemed justified with the earnings miss." Well, that's a very mature thing to say. "But after listening to the earnings conference call, I had concerns that this small-cap company may be facing long-term problems. Are there specific things in conference calls or earnings reports that make you pause and think, 'I may need to consider selling this one? Thanks for considering my question."' You're welcome, Mike. Thanks for your question. I'll give you two, quick thoughts on this.

The first is when I'm listening to a conference call or just reading what people are saying online in an earnings conference call, I often listen for whether we're hearing what I'll call "corporate speak" or, by contrast, an authentic human voice. This is not a fail-safe, catchall panacea for avoiding all kinds of mistakes by holding or not holding onto a stock that has been downed badly.

But when I hear from real people real language explaining the mistakes that they made, the problems they have... When the Domino's Pizza (NYSE: DPZ) CEO comes on and says, "Our pizza's just not good enough. Let's face it. We need to fix that," that kind of talk makes me feel really good about continuing to hold a company. Whereas if I'm just hearing the CFO read the boilerplate in front of me, and not really address what's happening with the company or try to put a good face on it, then I'm less likely to hold.

Again, I don't want to hold out any single factor or any single line or pose from an earnings conference call as the one decision point that you should make -- the one-factor decision that you'll make about a stock -- but I do listen for these things.

And then my second thought is always revisit the reason that you bought a stock in the first place. One of the things we do in our services is in both Motley Fool Stock Advisor and Motley Fool Rule Breakers, we have something I developed called the five-and-three, and that represents five things that we're looking for in future. Going forward five things we're looking for from a stock.

And when we see them that will be a good sign. We call those "green flags." We're looking for five green flags. Then we include three "red flags," as well. Three things that if they happen in the future, that would make us think harder about selling. So, that's the five-and-three. The reason we have more green flags than red is because we're optimists. I think that's the right approach you should take to life, let alone the stock market. We're looking for good things if we're going to recommend a company. We probably have more good things in mind than bad.

But you know, Mike, that might be something that you want to start doing, if you're not already. Before you buy a stock, list for yourself, briefly, the reasons that you're buying it or what you're looking for. If you're seeing, based on a big drop that the stock's taking, that it's driven by news that aligns with some of the bad stuff that you're hoping not to see, that might be a reason to consider parting ways.

And you should always consider the idea -- and I've done this many times myself with many losing stocks -- that so long as you don't add to a losing stock, when that stock nosedives, and some of ours always will, it becomes less and less relevant to your overall net worth. Assuming you're not adding on the way down, which I rarely, if ever, do, it becomes less and less consequential because your winners will wipe out your losers and you don't need to fret those big drops as much as most people, I think, tend to. Thanks for your question, Mike!

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