How to Distinguish Between a Stock Bargain and a Future Money Loser

Many years ago, investing great Peter Lynch wrote: "Selling your winners and holding your losers is like cutting the flowers and watering the weeds." And that's not a strategy anyone should be following. But there are other ways to water your weeds, such as expanding your positions in companies whose share prices are falling for good reason.

In this mailbag segment of the Rule Breaker Investing podcast, Motley Fool co-founder David Gardner and Chief Investment Officer Andy Cross field a question from a listener who is trying to figure out how to recognize when a share price dip is an opportunity, rather than a developing weed.

A full transcript follows the video.

This video was recorded on Nov. 28, 2018.

David Gardner: Mailbag item No. 3. Andy, let's do it! This one comes from Australia. Colin Anderson writes in, "Dear Motley Fool team, since joining Motley Fool Stock Advisor and Rule Breakers in the U.S. and Stock Advisor and Dividend Investor here in Australia, all Motley Fool services, in the last four years, I've become an educated, enriched, and entertained investor. I'm especially" -- he's going to keep going with the alliteration here -- "I'm especially wiser, wealthier, and wwwwwwwwell prepared [ugh] for market volatility. During the recent bumpy ride through the past few months, I've slept well, been quite relaxed, but a little sad that my liquidity didn't allow me to buy more in the dip." He didn't write "on the dip." Here in America, we say "buy on dips." This is, maybe, an Australian English approach here, buying in the dip.

Andy Cross: Could be!

Gardner: We'll get back to that in a little bit. Let's continue. "Your services point me toward better companies, better investing, and a better future. Thank you for all the fantastic services. Now, to my question. I used to wait until I accumulated about $5,000 before investing in any stock. That was the limit my old broker set before bumping his charges from $50" -- that's the commission rate -- "to 1% of the purchase price. Ouch. My new broker now charges" -- this is the better world we're living in now -- "$15 flat. Still high by U.S. standards, but better." Certainly, we agree.

"Thanks to some great tips from you all, I've started to dollar-cost average my entry into a new stock." We just talked about that. Regular investment, adding to winners. "In my old style, I bought bigger chunks and often added to my weeds as I tried to lower my average purchase price. I lost bigger than I would have lost in the Foolish style of investing. But even with your sage advice, I've only learned the painful lessons of watering weeds this year. I recently started small positions in Intuitive Surgical, Shopify, MongoDB, PayPal, and JD.com. I've added to Shopify and MongoDB. Now, the recent slide in the market has opened up a question: Do I buy" -- here it is again, Andy -- "in the dip? Or, would I be watering my weeds again? In my specific case for these current stocks" -- the ones I just mentioned, Intuitive Surgical, etc. -- "I have confidence in these companies. The reasons for selecting them have been Foolish, not foolish. The market drop has been a vote against the broader market. I've seen nothing against the weight of these companies. But how do I recognize a dip or distinguish it from a developing weed? Yours Foolishly, Colin Anderson."

Andy, I laid a lot of scaffolding there. Colin shared where he is in his investment journey. But fundamentally, the question is this: When a stock drops that we like, how do we know whether it's just dipping and going to come back or one of those weeds that you don't want to keep watering?

Cross: It's a great question, Colin. Making the distinction between watering your weeds -- and when we say "weeds," we mean, at least I mean, and I hope Colin means this, as well, companies that have a lower stock price, and maybe the business has deteriorated a little bit, and it's a smaller part of our portfolio, so we are dollar-cost averaging our price down a little bit.

Gardner: A lot of people do that!

Cross: A lot of people do it.

Gardner: But Andy, you and I know, the reason we call them weeds is, those are the ones that you shouldn't have done that to.

Cross: That's exactly right.

Gardner: You don't want to water the weeds.

Cross: You don't want to water the weeds. The full saying is "water your weeds and trim your flowers." You actually want to water your flowers, because those are the businesses that are going to continue to hopefully win in life and support the great things they are doing around the world. Also, that's good for shareholders. Supporting those businesses and investing your hard-earned capital into the businesses that are doing well.

Now, to your question, the difference between watering weeds and watering businesses like Intuitive Surgical and Shopify, that have gone down, that have pulled back. The first thing I would say is, has the market pulled back in general? Is whatever general market index you look at -- and certainly, the last couple of months, the S&P 500, the most general market followed here in the U.S., it's different around the world. In Australia, it's the ASX 200. Whatever it might be. The general market, has that pulled back as well? Have my stocks pulled back with that? So, first of all, how has your stock performed against the general market?

Gardner: Right. If the whole market's selling off and your stock's with it, that probably doesn't indicate they're weeds.

Cross: Not by itself, it certainly doesn't.

Gardner: Right. The whole market sold off.

Cross: That's right, exactly! That's the first thing. The second thing is, then, look at the performance of your businesses. Go in and see. You can go on fool.com, the fool.com over in Australia, and pull up a ticker to see if the business continues to grow. If the business seems to continue do well, as Intuitive Surgical is, as Shopify is, as so many of our businesses continue to do, then I would see that as an opportunity to add on that weakness in price. But hopefully, you're adding on the strength of the business. That's the difference.