With the recent sell-off in the stock market, many out there may be thinking about buying a stock that has declined in price recently. It is always tempting to buy a stock that has gotten clobbered. Sometimes a stock will miss earnings by a penny and then fall 15%. What are the right times to buy falling stocks, what are the right kind of falling stocks to buy, and how should you buy them?
Buying stocks that have fallen significantly and are therefore below fair value is a strategy called “value investing.” Value investing is not recommended here since it is often risky. The reason is that the stock value investors favor tend to be distressed companies – those that look like they might go under anytime, but are just so cheap that one can’t help but think of the huge profits that can be earned.
I was reminded of the dangers of value investing last week when I briefly thought about snapping up some shares of Borders. After all, they were selling for just about $0.30 each. I figured for a few thousand dollars I could get 10,000 shares or more. If the stock went back to $10 or so, I would have $97,000 profit – not bad. Luckily for me I tend to procrastinate, because the company announced a couple of days later that they were filing for bankruptcy and existing shareholders would be wiped out. This is the fate of many value investing positions.
So when would I recommend buying falling stocks, and what kind of stocks should be purchased? During 2008 especially and during the recent fall-off to a lesser extent, virtually the whole market declined in lock-step. An analyst would say that stock movements were highly correlated. This means that all stocks, good and bad, were selling off. Quality companies that were doing just fine were being sold simply because investors were scared and wanted to go into cash. It is at this time that the same quality growth companies that are the focus of our long-term strategy can be bought up cheaply. As always, look for stocks that have been growing earnings regularly, have little or no debt, and are the best in their market segments. Remember that just because a stock is cheap does not mean that it is a bargain.
When purchasing, remember that bubbles expand longer that anyone thinks they will and collapse for much longer than anyone thinks they will. This means that even though stocks may look cheap, there is no reason to expect that you will make a buy and see the shares stop their fall and turn upwards. For this reason, the thing to do is buy in increments. Buy perhaps 1/3 of the position you would eventually like to own, wait for a further fall, buy another 1/3, then wait for one more fall and make your final purchase in the stock. After that point, just forget you own the shares and wait – this is a game of patients.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing