Buying Strategies
Part II: Buying Points
September 21, 2007
By Chandler Lutz
This is the second part in a three part series
Once you find a great company how do you know if it’s the right time to buy? After all, a great company bought at the wrong price can lead to very unsatisfactory returns.
Obviously, valuation metrics can tell us a lot about a company. Tools such as the p/e ratio and price/book can give us an idea of how expensive or cheap a firm may be, but these ratios don’t necessarily help you maximize returns
In his classic investment book, Common Stocks and Uncommon Profits, Philip A. Fisher describes how certain buying points arise for a firm. The notion of a “buying point” revolves around the idea that a jump in profits in the short or medium term will propel a stock price upward and bring great returns to shareholders. Fisher identifies two distinct buying points: (1) Temporary bad news has surrounded the company which has depressed the stock price to abnormally low levels and (2) an unexpected surge in profits is about to occur. Let’s examine these buying points individually.
(1) Temporary bad news surrounds the company:
This is the classic value investing play. In even the best of companies, things go wrong from time to time. Either a research endeavor fails, bad news surrounds an industry, or something else entirely unexpected occurs. When these events happen, acute investors are always waiting in the wings to take advantage of the market folly. Legendary investors such as Benjamin Graham and his disciple Warren Buttett have achieved spectacular returns by “buying stocks on sale.”
One of the classic buying points regarding bad news involves an earnings miss. Often times when firms fail to meet analysts’ earnings expectations share prices can often tumble substantially. When you understand a company, this is the perfect time to buy shares if you are confident in management’s abilities and the firm’s prospects.
Just as with everything, there’s a catch: You have to be confident that the bad news is indeed temporary. If the bad news is of a permanent or indefinite nature, then your investment may be a lot of trouble. The better you know a company, the more adept you will be in analyzing any news that may affect your investment decisions.
(2) An unexpected surge of profits is about to occur:
This may be a much more difficult buying point to discover, but it can be very lucrative. Whenever a company is going to see a surge in profits it may the right time to buy. This jump in earnings can occur when the company resolves longstanding problems, increases efficiencies in some way or is developing a new product. A classic example is when a manufacturer develops new techniques that increase the efficiency of a plant which allows the firm to produce more products at a lower cost.
Again, with this buying point there is catch. The potential rise in profits has to be unexpected. If the market values this upswing in earnings the same way that you do, then you may not realize as large of returns as you would like. Your valuation metrics can tell you a lot about this topic. For example, if you see a large jump in the p/e ratio, then the market may have already discounted the surge of profits. However, if you were to see little change in this earnings multiple, then you may have found yourself a bargain.
Similarly to buying point number one, the better you know a company the more able you will in assessing the potential surge in profits.
Overall, these buying points can be a powerful tool. They become more powerful if you combine them with in depth research and your amateur’s edge. It is also important remember that a buying point is worthless when the firm’s business model isn’t solid. A bad company at a great buying point isn’t a worthwhile investment.
Part III of our Buying Strategies series is coming soon.
You can check out part I of the Buying Strategies Series by clicking here.
For more articles on strategy you can check out the Investment Strategy section of StockBoxFinancial.