Value investment strategy tells us that when you find a stock of good quality and is trading below its intrinsic value with a comfortable margin of safety, you buy it and hold until the fair value is recognized by the market. This is the theory. But in practice, we often find that the process of realizing the capital appreciation is not linear, like Figure 1, but it’s more like Figure 2 where you don’t make any profit in the first couple of years. Or even worse, like the Figure 3, when the stock price drops after purchase, leaving you a number of years with negative return.
Figure 1
Figure 2
Figure 3
Having such experience, I asked myself: Why did I buy in year 0? Can’t I wait until year 4? In the first four years, if I put the fund into other stocks or other investments, I will achieve a much higher portfolio return by the end of year 10.
Obviously if you know the stock will rebound from year 4, you will definitely buy into it in year 4 instead of year 0. The problem is how you can get the foresight. Today, I would like to discuss whether we can improve our timing skill when comes to buying an undervalued stock. Note that this is not a discussion of timing the market, but to find ways to put the value investment strategy into better practice.
To answer the question of when to buy into an undervalued stock, we should first understand under what circumstances a stock is undervalued by the market. I think it can be roughly divided into three circumstances.
1. Macroeconomic problem
2. Industry headwind
3.The company itself is having trouble and is sailing through a turnaround
Situation 1, such as the 2008 financial crisis when the whole stock market tumbled, creates a rare opportunity for investors. There isn’t much opportunity cost for buying a stock at wrong time as all the stocks plunged. I won’t touch it too much. I will focus on the second and the third situation. Today I will look into industry headwind and will leave the discussion of company’s internal problem to part 2 of this series.
Industry headwind
This is very typical in cyclical stocks, but it’s not limited to cyclical stocks as almost every industry experiences ups and downs. When an industry is experiencing a headwind, individual stocks in the industry will drop. Or we can say the market is pessimistic and pushes the stock price down. When this opportunity arises, many value investors will jump in immediately. However, we all have the experience that the stock price usually hovering at the depressed level for couple of months or even years. So instead of “buy and wait”, we’d better off if we “wait and then buy”.
Let’s take Deere & Co. for example. The stock price has been levelled off in the past two years due to the weak demand in the farm sector. Falling corn price resulted in lower farmers’ income that led to weak demand for farm equipment. Figure 4 is Deere’s stock price in the past five years. If we just look the past two years, we find that Deere’s stock price was barely changed. On 29th April 2013, it closed at $91.54 and on 2nd May 2015 it closed at $91.39. In other words, if you are in favour of Deere, impressed by its solid earnings and consistently high ROE and think it has a moat but it’s undervalued, you can initiate a position at any time during the past two years for a price between $80 and $90.
Figure 4 DE stock price 04/2010-04/2015
Source: finance.yahoo
However, the time you buy the stock will impact the compounding return you can achieve. Let’s assume by April 2017, the share price increases to $110. If you bought it in April 2013 at $90 for example, your compounding rate will be a mere 5%. If you buy it today at the same price (This is an example for illustration only, not a recommendation to investors to buy DE now.), your CAGR will be doubled.
Figure 5
| Buying date | Holding period | CAGR |
| 04/2013 | 4 years | 5.1% |
| 04/2015 | 2 years | 10.6% |
People may say Buffet has bought it quite a while ago and he hasn’t got any capital appreciation either from Deere’s. My thought is: first, investors should not blindly follow the gurus without doing their own research; second, if you have a small fund, you can’t build up a position in the way Buffet did. Mr Buffet can keep adding to his holding without significantly impact to his whole portfolio. For example, for the three months ended 31/12/2014, Buffet added to his holding of Deere’s by 125.93%, but the impact to his portfolio is merely 0.78%. Smaller investors may not be able to lavish the buying opportunity. I have been in the situation of after holding the stock, the price dip further, making it more attractive. But from a portfolio allocation point of view, I will not add more to the holding.
I am not here advocating a market timer. But just express my point that though as value investors we take “long-term” view and are unaffected by the market price, buying at the wrong time does affect our long-term investment return. In my opinion, holding a stock without any price appreciation or with very little appreciation for years is a waste of the capital. The money can have a better use. (As a side note, readers should be aware that the faster the portfolio turnover, the higher the portfolio’s return. For more details of this viewpoint, please refer to the article “Portfolio Turnover-A Vastly Misunderstood Concept” by John Huber in his Base Hit Investing blog.)
It’s easier to say than done. Let me move to the discussion of what we can do here to increase the chance of buying at the right time. My view is: first, doing some research on the industry is necessary. You won’t buy an agricultural stock without even looking into the corn price. Even if you can’t tell exactly when the industry will recover, at least you have an idea that it will continue to be bleak for another two or three quarters, for example. Then you won’t jump in immediately. Second, the management’s earnings’ call usually gives hints. The management usually discusses the operations of the business, for example the demand for their products and their forward looking. It’s better to start a position of the stock when there are signs that the industry headwind is retreating.
Some people are afraid of missing the best buying point. My observation is that people tend to have more forgiveness to the “opportunity cost” they incurred for not putting the money into an alternative investment with better return than to the missed bargain for not buying earlier at a lower price. I guess the reason is because the former is not as visible and measurable as the later. For me, I don’t expect myself to have the genius to catch the lowest price of the stock. Look back to Deere’s. If I missed out the lowest $80, I am fine with $85 so long as it still leaves me the margin of safety that I am comfortable with (This is just an illustration, not a buy price recommendation. Investors should do their own researches.) Mr. Market usually gives us numerous buying opportunities that we can seize. It is what you are expecting yourself that counts. Figure 6 compares the return of buying earlier at a lower price to buying later at a higher price.
Figure 6
| Purchase Date | Purchase Price | Closing Date | Closing Price | CAGR |
| 06/24/2013 | 81.25 | 05/02/2015 | 91.39 | 6.6% |
| 08/25/2014 | 84.09 | 05/02/2015 | 91.39 | 13.3% |
As you can see, even if you bought it at a few dollars higher in August 2014 than if you bought it in June 2013, you shunned the lacklustre of the stock performance for fourteen months, which gave you a CAGR of 13.3%, doubling up the return you would get if holding since June 2013.
To sum up, when a stock is undervalued and a buying opportunity arises as a result of an industry headwind, one should wait to buy until there are signs that the industry headwind is dispelling.
I welcome your thought on this part from your experience.
