Dollar Cost Averaging in a Down Market
It's difficult, if not impossible, to determine a company's true value at a given moment in time, and the recent drops in many stocks goes to help prove that.�Today George Runkle looks at this situation from his engineering standpoint, and concludes that the solution is quite logical -- dollar cost averaging, of course!
By George Runkle (TMF Runkle)
October 10, 2000
Out of curiosity, I checked to see how far shares of Scientific-Atlanta (NYSE: SFA) have recently dropped. If you check the Fool's historical quotes, you see that Scientific-Atlanta traded at $70 on September 11 this year. By October 6, it had dropped to $53. Ouch! That's a 23% drop in less than one month. So, what happened? Did everybody give up on cable TV?
I did a quick search for news about Scientific-Atlanta and I found nothing that would explain the drop. Instead, I believe that the stock got hit with most other technology-related stocks. Does this decline mean Scientific-Atlanta is selling cheap? Should you rush out and buy loads of shares? Or does it mean that the company is going down the tubes and you need to join in and dump your holdings at a loss? The answer to both questions (in my opinion) is no. However, the behavior of this stock and so many like it provides a renewed, strong argument for the advantages of dollar cost averaging in commission-free Drips.
First, how do we really know what Scientific-Atlanta is worth? In previous columns, we've talked about the difficulty of accurately valuing a company. So many factors come into play. The biggest problem, though, is that we're forced to make loads of assumptions that may or may not be accurate. Depending on a person's outlook, a company can have wide variations in perceived value.
We see that nearly every month with Scientific-Atlanta. In a space of less than 30 days, the market has determined that the company is worth 24% less although nothing significant happened to make it less valuable. So, maybe it's a good value now. On the other hand, maybe everybody was overly optimistic, and the stock was overpriced on September 11. I'm sure that I could make a convincing argument, complete with calculations, proving either point of view.
As an engineer, the thought of this ambiguity bothers me. I know all of the stereotypes about engineers, and most of them aren't true. I did have dates in high school (OK, not very many, and a lot of them were blind dates). However, engineers do like logic, and there seems little logic in how stocks are valued by investors. (How can some companies be worth $100 a share one day, and $5 a share 10 months later, as has happened to so many Internet companies?)
This uncertainty always leaves a problem hanging out there: How do we buy a stock at a price that will get us a strong return? If we bought Scientific-Atlanta on September 11, we could be waiting a long time to get any kind of return on our money. Actually, the same could happen if we bought into Scientific-Atlanta on October 6. The downturn of the market may not be over.
However, engineers (like me, anyway) solved this illogical problem in a logical way that would even make Dilbert smile. As Drip investors, we buy a fixed amount of stock on a regular schedule. So, if you invested $100 in Scientific-Atlanta on September 11, you bought 1.42 shares. If you then invested $100 on October 6, you bought 1.85 shares. Hey, you bought more shares at the lower price!
Better yet, if the stock keeps on dropping, and goes down 24% again in 30 days, you'll do better on the next purchase. The stock would be down to $40.99, and you will buy 2.44 shares at the new and improved price, yet using the same amount of money. You don't have to worry about timing your purchase, and in the long run your average cost per share favors the lower end of the price range.
So, as we watch the market behave like it wants to give up on life, we just go merrily along making our Drip purchases. This is a solution that every engineer would love; just like those plastic things that you put in your shirt pocket to prevent the ink stains. You don't even need a scientific calculator to do it (although having one is something to consider).
Today, executives from Nortel Networks (NYSE: NT) are visiting Fool HQ, and we'll be talking about a number of things that I will report on in our next Drip report. If I may, I'd like to recommend The Motley Fool Research Internet Report on the Wireless Web. I particularly recommend Paul Larson's analysis that begins on page 6. It's a great overview of the entire industry as it is developing, and it outlines the leading companies.
Until the next time, stay Foolish. Oh, and check out these engineer jokes (if you must).