Buying
Ignore the welter of news and views
Investors who buy common stocks directly are concerned about price vs value. Investors in mutual funds and ETFs are price acceptors. That is, since they have no way to gauge whether they are getting value for their money, they just pay the market price, no questions asked. Common stock investors need a thoughtful buying process to ensure they can take advantage of the work they have done in finding superb companies to invest in at very attractive prices.
Waiting for a pitch in the happy zone
There is a world of difference between buying for a well-established portfolio and starting a new portfolio. For my portfolio, I may add (and subtract) only one or two companies a year in any year. The stock I’ve held the longest in my portfolio I first bought over twenty years ago. In the last three years only a small number are new to the portfolio.
Great investment ideas don’t come along very often. Building a new portfolio is difficult because it takes time. For a new portfolio, it is almost impossible that there would be, at one time, a sufficient number of superb companies available at bargain prices. Be patient.
Readers can try a small quiz. You are looking at putting some money to work in the stock market. You see shares of a fair company available at a great price. You also see shares of a great company available at a fair price. What do you do? Answer: nothing.
Neither of these investments should be made by the intelligent investor seeking superior returns.
We live in constant fear of missing out on opportunities. Day by day we see the price of stocks in ordinary companies moving up. It takes patience to sit back and watch them go. It take tremendous discipline to wait for the right pitch. You get a free look at as many pitches as you like.
Buying at the bottom
Should we try to buy at the bottom? The approach to buying by Oaktree Capital is described by Howard Marks. He points out that you simply cannot know whether one is investing at the bottom: “It’s just not realistic to expect to be able to buy at the bottom.”
And he adds the insight: “It’s essential to understand that “cheap” is far from synonymous with “not going to fall further.””
So – “How does Oaktree resolve the question of knowing when to buy? We give up on trying to attain perfection or ascertain when the bottom has been reached. Rather, if we think something is cheap, we buy. If it gets cheaper, we buy more.” (Marks, 2013)p.212
This advice is really quite profound. It is certainly in tune with keeping it simple. One focuses on buying when the stock is a bargain. It is Benjamin Graham’s timing by way of price looked at in an earlier post here.
Time of maximum pessimism
There is a feeling in the air when individual stocks or the market as a whole is in the dumper. It’s a ‘time’ of pessimism, not a ‘point’ of pessimism.
Three of John Templeton’s 22 Maxims deal with buying. To remind the reader, they are:
4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
5. To put “Maxim 4” in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
6. To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Of course one cannot gauge in any objective psychological way a time of maximum pessimism. One can feel it.
Many readers will remember the mood in the market at the end of 2008 and the first three months of 2009. That was a time of maximum pessimism!
Readers wishing to read a little more on this look at: Section 42.04 Point of maximum pessimism
Concerns about the market and the economy
When we find a wonderful company at a great price we can largely ignore the welter of news and views about the stock market at large. It doesn’t matter if the crowd is cheering wildly or in distress. Pundits are constantly talking about the outlook for the market or the economy. The level of the S&P 500 is analyzed based on historic price earnings ratios and the current CAPE ratio. This is simply distracting.
The larger market and the economy are both complex and confusing. How are we to know how the business cycle will unfold in the next three to five years?
What we can focus on is the opportunity presented by the purchase of an individual stock. This is a much more manageable assessment. Again, we are keeping it simple
Investors need to understand that individual stocks can become bargains regardless of what the overall market is doing. We need to internalize this idea. I outline some of the ways in which this can happen in a post here.
How much to buy
I won’t get into this in detail. It’s really another subject. Suffice it to quote Warren Buffett: “In the words of the prophet Mae West: “Too much of a good thing can be wonderful.” (Buffett, Cunningham, 1998) p79
A word about the Kelly Criterion. The idea is that one apportions investment positions or portfolio weightings according to one’s informed estimate of each stock’s probable return; it is the weighting that provides the highest geometric mean of outcomes; betting your beliefs. See my post here.
Scaling
T. Rowe Price is described as using a scale buying approach using a target price. “As a stock falls to his target buying range he starts buying quite vigorously, without ‘bottom fishing,’ which he clearly feels does not pay. If a stock goes a lot below the initial price he paid, he will have done some buying near the lows, but most of his buying will average out not too far below his initial target price.” (Train, The Money Masters, 1980) p151.
A large institutional investor may buy portions of a full position over time simply because there is simply not enough market liquidity to purchase a full position all at once. It seems that T. Rowe Price used scaled purchases over time as a tactic rather than to overcome liquidity issues. I’ve read that it took Buffett three months of careful buying to acquire Berkshire’s Coca Cola position. Individual investors essentially have no liquidity issues.
Years ago I used to buy what I called a starter set in a company. I found that even with a relatively small position I paid attention to what was happening in the company and also was more sensitive to what was happening in its industry. For the starter set I was not too concerned about price as long as I did not pay over fair value.
The problem I found was that I accumulated small positions in a variety of companies which never found their way into the bargain bin. My efforts in following the company were very often not rewarded.
My approach has evolved and is still evolving as I develop more experience. I currently follow a practice that when I find a superb company at a bargain price that I want to invest in I will initially buy a ½ or even 2/3 position. If I am aiming for a final 7.5% weighting in the portfolio, I will purchase at least a 3.5% weighting initially and perhaps 5% or more. This gives me the opportunity to reflect further on the wisdom of the purchase when I have skin in the game. It prompts me to pay attention to the company and the sector it operates in. I will buy the rest of the position in relatively short order.
I like to think of this first substantial purchase as a challenge to the market. I dare the market price to go down further. Sometimes one buys a position and the market promptly goes down. If I’m still confident in the company I will happily buy the rest of a full position.
Averaging down
Averaging down can be a fools game. There are significant behavioral pitfall. Holding losers and a fear of getting whipsawed can initially lead to risk averse behavior and, as the potential loss deepens, may lead to risk seeking behavior. Knowing when to cut a loser is critical. See my post here.
See also Section 42.07 Averaging down
Averaging up
If the stock goes up, I may soon decide to buy the balance of the position. This also carries some psychological baggage. The price we paid originally acts as an anchor. We may think that anything over that price is over-paying. In truth, the price originally paid is irrelevant. All that matters is whether the current price is very attractive in relation to fair value.
Conclusion
In some ways buying is easier than selling. But there are some subtleties to it. It is part and parcel of what Ben Graham would have called principles of operation. The current expression is investment process. Getting your buying right makes the rest easier.
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Several section of the Motherlode add to the discussion on buying. See Sections:
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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