Knowing the right time to buy a stock is not about trying to find the perfect bottom. Conversely, knowing when to sell a stock is not about hitting the perfect top. However, buying or selling decisions can and should be based on the timeless principles of business, economics, and accounting. In the short run, stock prices can behave very irrationally, if driven by fear or greed. Over time, however, the evidence supports the idea that stocks will eventually seek their fundamentally supported values.
In Part 1 of this two-part series, we focused on overvaluation when fundamentals remained solid and price ran away. In Part 2, we will first look at fundamental deterioration as a sell signal. Although less obvious than pure overvaluation, fundamental weakness can be discerned and responded to.
After reviewing poor fundamentals, we will examine a few current examples of possibly overvalued companies. It’s important to note that stocks generally become overvalued when they are most popular. This is usually also a time when investors are overconfident as well. Don’t mistake exuberance for optimism, the first is often illogical. Exuberance, irrational or otherwise, rarely serves investors well in the long run. Optimism on the other hand, is a more reasoned attribute and one that most of history’s most successful investors possess.
Our Fundamental Research
Once again, we will turn to our EDMP, Inc. F.A.S.T. Graphs™ (Fundamentals Analyzer Software Tool™) to illustrate our points. Figures 1 and 2 below revisit Home Depot (HD) and General Electric (GE), i.e., two examples from Part 1. Not only were these two stalwarts victims of irrational exuberance in1999, they went on to become victims of fundamental deterioration during the 2008 recession.
In Figure 1 below, we expand Home Depot’s historical graph beyond the 2006 period we showed in Part 1 of this two-part series and bring it up to current. As you can see, earnings growth first slowed or flattened in 2006 (red circle), before falling significantly over 2007-2009. Stock price (black line) followed earnings down (green line with white triangles), and are now rising as estimates imply growth in 2010 over 2009 (blue circle).
Figure 1: HD 15yr EPS Growth Correlated to Price 
(click to enlarge)
In Figure 2 below we revisit General Electric Co from Part 1. Like we did with Home Depot, we update price and earnings to current. Earnings fell precipitously in 2008. By the third quarter ending September 30, 2008 it was clear that GE’s streak of consistent earnings advances was likely to be broken (red circle). Heeding the sell signal anytime in 2008 would have reduced further losses dramatically.
Figure 2: GE 15yr EPS Growth Correlated to Price 
(click to enlarge)
Overvaluation Rare Today
Thanks to the recession of 2008 most frothy valuations were wrung out of the market price of most stocks. Nevertheless, our research has taught us that in every market environment there exists overvalued, fairly valued, and undervalued companies. Obviously during extreme bull markets like we saw from 1995 to spring of 2000, fair or undervalued selections were scant. Conversely, after the recent severe correction in 2008, overvaluation has been harder to find.
What often amazes us is how quickly and easily investors can forget the lessons from history. Although we had to look hard to find them, below we offer two examples of extraordinary growth stocks that appear to have gotten ahead of themselves pricewise.
In Figures 3a and 3b below, we examine Green Mountain Coffee Roasters (GMCR) a strong contender in our mid-cap growth universe that appears currently overvalued. This is a company we like, but would only be a buy when valuation makes sense.
Figure 3a below shows that Green Mountain Coffee Roasters became overvalued starting in October 2006 (red arrow) before eventually reverting to the mean by October 2008 (yellow arrow). A sale of this stock any time towards the latter half of 2007 would have been a sound sell decision. Buying the company back in the fall off 2008 through the spring of 2009 would also have made sense.
Since 2007, and including a consensus for growth of between 75-100% for the current fiscal year, Green Mountain Coffee’s earnings growth calculates at an average better than 60% per annum. This is approximately double their 15-year (14+) historical earnings growth rate of 32.2%. (See Figure 3a)
Figure 3a: GMCR 15yr EPS Growth Correlated to Price 
(click to enlarge)
The question that begs to be asked is: How sustainable is Green Mountain’s recent 68% plus earnings advance? In Figure 3b below, we show a calculation of the forecast from ten analysts reporting to FirstCall of 28% growth for the next five years. Zacks reports a consensus 5-year forecast of 31% earnings growth.
Both of these numbers are consistent with longer history and could conceivably be achieved. On that basis, Green Mountain Coffee Roasters is a sound sell candidate. Common sense would further suggest that after such a strong run up, prudence would be in order. Therefore, at least taking some of your money off the table might be wise.
Figure 3b: GMCF 5y EPS Growth Forecast 
(click to enlarge)
Figures 4a & b look at Cerner Corp (CERN), a leading healthcare information technology solutions provider. Figure 4a illustrates several periods of overvaluation all ending the same, with an eventual reversion to the mean. At over 35 times earnings, Cerner commands a P/E ratio of 2.4 times its 14.8% historical earnings growth rate.
Figure 4a: CERN 15yr EPS Growth Correlated to Price 
(click to enlarge)
Figure 4b below shows a calculation of the consensus five-year forecast growth rate of Cerner by 22 analysts reporting to FirstCall. Of special note is the fact that the forecast 19.3% earnings growth rate is much higher than its historical norm of 14.8%. This acceleration of growth particularly explains recent exuberance. However, in our view, the P/E ratio of 35.5 is not justified by those estimates.
Consequently, we rate Cerner a sell candidate based on overvaluation. Incidentally, we sold Cerner in our mid-cap portfolio in December of 2009 at approximately $77 per share. Obviously, not a perfect top, however, we stand behind the decision as a long-term sound one.
Figure 4b: CERN 5yr EPS Growth Forecast 
(click to enlarge)
Conclusion
Knowing the perfect time to sell a stock is simply not possible. However, knowing sound times to sell, we believe, is achievable. It is simply about running the numbers out to their logical conclusion. When results make no economic sense, selling is generally a good long-term idea.
We believe that overvaluation, especially extreme overvaluation, is most often obvious to the diligent observer. Fundamental deterioration is a little trickier to determine, but with through research, can be accomplished as well. The key is to make sound decisions based on realistic assumptions. Avoid both hype and/or hysteria at all costs.
Disclosure: No positions in these at time of writing.
