One of the great things about advising the Motley Fool Hidden Gems newsletter is that I have the opportunity to talk with subscribers about investing questions they have. Some of them are asked so often that it makes sense to publish the response so everyone can benefit.
The question is this: You buy a stock, you love it, and you love the price. Sadly, the market fails to recognize your pure genius and knocks the stock price down further. At what point do you buy more? Should you wait for a 10% drop, 20%, 40%? There must be a certain percentage drop at which you should buy more, nearly automatically. Right?
Price doesn't matter. Value does.
Actually, the answer is no. One of the more common mistakes investors can make is anchoring decisions based upon their original purchase, or if they're purchasing, on the original price at which they saw the company. I wrote about this in July in an article titled "Nobody Cares What You Paid."
There are few mental errors more widespread than anchoring. At the Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) annual meeting in 2004, Warren Buffett said of his experience buying Wal-Mart (NYSE:WMT) several years ago:
I cost us about $10 billion. I set out to buy 100 million shares, pre-split, at $23. We bought a little and it moved up a bit and I stopped buying. Perhaps I thought it might come back a bit, who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot.
Buffett anchored on a price, and it was costly. (Given Berkshire's long-term returns, I assume most shareholders join me in forgiving this little misstep.)
But that's when the price is going up. The question at hand is what to do when the price has dropped, but nothing else has changed. My answer is that it is a buy anywhere from slightly above the purchase price to as far down as it goes. After all, if it was a buy at the higher price, why isn't it a buy now? And if that was the case, why isn't any price below the price where you originally considered it a bargain a great price?
I took a great deal of flak when I wandered into the great retail hate-fest in late September and recommended buying shares in New York & Co. (NYSE:NWY) for a second time when the stock was down some 20% from its original recommendation price. Why wouldn't I? I'd already determined at several dollars higher per share that I thought management was executing its restructuring program very well. So nothing changed, and at $14, the stock was dirt cheap.
Buy when you can
Our philosophy tracks that of investing legend Shelby Davis. When asked about the best time to buy stocks, he said simply, "When you have the money." He turned a $50,000 grubstake into a fortune approaching $1 billion by doing things like not particularly worrying about the direction of stocks. He lost more than a few dollars when he guessed wrong, but these losses were completely outweighed by his penchant for buying great companies when the market was terrified.
In fact, not only do we try not to focus on whether a stock has fallen from our purchase price, we don't even particularly care if it has risen as long as the company's prospects remain undervalued. Tom Gardner has recommended Middleby (NASDAQ:MIDD) on multiple occasions, even after it has doubled and tripled. He did so for the exact same reason that I re-recommended New York & Co. In spite of a phenomenal rise in share price, the stock was, in Tom's opinion, still cheap. Similarly, our best-performing stock in Stocks 2005, which also doubled, had such a strong growth in its business prospects that Charly Travers chose it as one of the best companies to own in Stocks 2006!
It doesn't always work out, of course. But by not worrying about what our original price was, we have the ability to focus instead on the prospects of an Elan (NYSE:ELN) or a UST (NYSE:UST) -- companies that the market has had good reason to hate at periods in their histories -- and get into them at prices that have the potential to be lifestyle-changing for us. Isn't that the point?
Hidden Gems recommendations are beating the market (as measured by the S&P 500) by more than 20 percentage points since inception in July 2003. You can view all of our picks (as well as everything ever published in our pages) for free with a 30-day trial. Did we mention it was free? Click here for the details.
Bill Mann is the co-advisor for the Motley Fool Hidden Gems newsletter. He owns shares of Elan, Berkshire Hathaway, and UST. A 30-day trial of Hidden Gems is available for free.
