One of the great things about advising the Motley Fool Hidden Gems newsletter is that I have the opportunity to talk with subscribers about their investing questions. Some of the questions get asked so often that it makes sense to publish the response so everyone can benefit.
One of the questions 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 on 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 annual meeting in 2004, Warren Buffett said of his experience buying Wal-Mart 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?
It's a simple philosophy: When nothing's changed, then nothing's changed. It's also how I've found some truly great investments. Tiffany (NYSE:TIF) is an excellent example. In 2002, its stock dropped by 50% in about four months, as sales, particularly in its Japanese stores, were extremely anemic. But had anything particularly changed at Tiffany? Sure, there is a rise of reputable online jewelry outlets, including Hidden Gems recommendation Blue Nile (NASDAQ:NILE), but Tiffany's position at the top of the jewelry food chain is fairly unassailable. Folks who piled in during the period when the market fretted about Tiffany have done extraordinarily well.
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, but we also don't even particularly care whether it has risen as long as the company's prospects remain undervalued. My recommendation of EPIQ Systems (NASDAQ:EPIQ), for example, came close to a 52-week high. Some investors might get nervous about that -- after all, companies can only go down from their highs, right? Not really. Stocks will follow the performance of their underlying companies -- loosely in the short term, but in lockstep over the longer term. EPIQ's growing, and I found the stock to be quite cheap. What it had done in the recent past wasn't a consideration. Why should it be?
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 a McDonald's (NYSE:MCD) and get into it at prices that have the potential to be lifestyle-changing for us. The stock market took companies that had real problems and discounted them to the bone. McDonald's was losing ground to competitors like Yum! Brands (NYSE:YUM) and Wendy's (NYSE:WEN) -- both very fine companies, by the way -- and was at one point valued below where it would be if the company were shuttered and the assets sold.
It was easy at that point to buy the gloom. It was also, as it turns out, the perfect point to buy the stock. The stock has nearly tripled since that time, when people came not to praise McDonald's, but to bury it.
Isn't finding opportunities like that the point of investing?
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.
This article originally ran as "Learn to Buy on Declines" on Jan. 10, 2006.
Bill Mann is the co-advisor for the Motley Fool Hidden Gems newsletter. He owns shares of McDonald's and Berkshire Hathaway. Blue Nile is also a Rule Breakers recommendation. The Motley Fool has a disclosure policy.
