Time to Sell Entropic Communications?

Should you sell Entropic Communications (NAS: ENTR) today?

The decision to sell a stock you've researched and followed for months or years is never easy. But if you fall in love with your stock holdings, you risk becoming vulnerable to confirmation bias -- listening only to information that supports your theories, and rejecting any contradictions.

In 2004, longtime Fool Bill Mann called confirmation bias one of the most dangerous components of investing. This warning has helped my own investing throughout the Great Recession. Now I want to help you identify potential sell signs on popular stocks within our 4-million-strong Fool.com community.

Today I'm laser-focused on Entropic Communications, ready to evaluate its price, valuation, margins, and liquidity. Let's get started!

Don't sell on price
Over the past 12 months, Entropic Communications is down 43.8% versus an S&P 500 return of 9.1%. Investors in Entropic Communications are no doubt disappointed with their returns, but is now the time to cut and run? Not necessarily. Short-term underperformance alone is not a sell sign. The market may be missing the critical element of your Entropic Communications investing thesis. For historical context, let's compare Entropic Communications' recent price with its 52-week and five-year highs. I've also included a few other businesses in the same industry or a related one.

Source: Capital IQ, a division of Standard & Poor's.

As you can see, Entropic Communications is way down from its 52-week high. If you bought near the peak, now's the time to think back to why you bought it in the first place. If your reasons still hold true, you shouldn't sell based on this information alone.

Potential sell signs
First, let's look at the gross margins trend, which represents the amount of profit a company makes for each $1 in sales, after deducting all costs directly related to that sale. A deteriorating gross margin over time can indicate that competition has forced the company to lower prices, that it can't control costs, or that its whole industry's facing tough times. Here is Entropic Communications' gross margin over the past five years.

Source: Capital IQ, a division of Standard & Poor's.

Entropic Communications has been able to grow its gross margin, which tends to dictate a company's overall profitability. This is great news; however, Entropic Communications investors need to keep an eye on this over the coming quarters. If margins begin to dip, you'll want to know why.

Next, let's explore what other investors think about Entropic Communications. We love the contrarian view here at Fool.com, but we don't mind cheating off our neighbors every once in a while. For this portion of our research, we'll examine two metrics: Motley Fool CAPS ratings and short interest. The former tells us how Fool.com's 170,000-strong community of individual analysts rates the stock, and the latter shows what proportion of investors is betting that the stock will fall. I'm including other peer companies once again for context.

Source: Capital IQ, a division of Standard & Poor's.

The Fool community is in the middle of the road on Entropic Communications. We typically like to see our stocks rated at four or five stars. Anything below that level is a less-than-bullish indicator. I highly recommend you visit Entropic Communications' stock pitch page to see the verbatim reasons behind the ratings.

Here, short interest is at a high 28.4%. A number like this typically indicates that large institutional investors are betting against the stock.

Now, let's study Entropic Communications' debt situation, with a little help from the debt-to-equity ratio. This metric tells us how much debt the company's taken on, relative to its overall capital structure.

Source: Capital IQ, a division of Standard & Poor's.

Entropic Communications has done a good job of wiping out its already-minor debt over the past five years. I consider a debt-to-equity ratio below 50% to be healthy, though the number varies by industry. Entropic Communications is obviously below this level, at a cool 0.0%.

The last metric I like to look at is the current ratio, which lets investors judge a company's short-term liquidity. If Entropic Communications had to convert its current assets to cash in one year, how many times over could it cover its current liabilities? As of the last filing, Entropic Communications has a current ratio of 9.86. This is a healthy sign. I like to see companies with current ratios equal to or greater than 1.5.

Finally, it's highly beneficial to determine whether Entropic Communications belongs in your portfolio -- and to know how many similar businesses already occupy your stable of investments. If you haven't already, be sure to put your tickers into Fool.com's free portfolio tracker, My Watchlist. You can get started right away by adding Entropic Communications.

The final recap

Entropic Communications has failed only two of the quick tests that would make it a sell. Does that mean you should hold your Entropic Communications shares? Not necessarily. Just keep your eye on these trends over the coming quarters.

To do that, I strongly recommend adding Entropic Communications to My Watchlist to help you keep track of all of our ongoing coverage of the company.

At the time thisarticle was published Jeremy Phillips owns no shares of the companies mentioned. The Fool owns shares of and has created a bull call spread position on Cisco Systems.Motley Fool newsletter serviceshave recommended buying shares of Cisco Systems. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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