“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” - Sir John Templeton
2016 just got started, but it’s safe to say we’ve found ourselves in a period of pessimism. Value investors live for these periods, at least in theory: falling prices are a reason to cheer. With nearly any name you can think of, expected returns are higher today than they were a short while ago.
In reality, losing money is a lot less fun. Even if you have nearly 25% of your portfolio in cash, like I do, the remainder of your portfolio is likely covered in red ink. When things really start to get ugly, most people have trouble convincing themselves to keep holding what they currently own – let alone going out and buying more.
It’s not a coincidence that the best time to buy is when few people have any interest in doing so.
There’s a story about Templeton that offers a good starting point for our discussion on buying in the face of pessimism (from an article by Charles Sizemore – link):
“The late Sir John Templeton had a great strategy for managing volatility and taking his emotions out of the equation. He would make a list of stocks that he would love to own if only they sold for a substantially cheaper price. He would then place limit orders to buy them at those prices. If a wave of panic swept the market, Sir John would not be paralyzed by indecision because the decision had already been made for him.”
That last phrase – the decision had already been made for him – really strikes a chord with me.
As I think about equity research, my goal is to end up with a rough idea of what I can conservatively expect to earn if I bought a company today and held it for the next five to 10 years. As an example, I might think a stock trading at $100 per share is likely to earn 12% annualized over the next five years, implying a future value of ~$176 per share.
From here, applying Templeton’s limit order strategy is straightforward: if your return requirement is 15% annualized, set the buy limit at ~$87 per share. If the stock falls 13% from where it currently trades ($100 per share), your order will be filled. This approach is beautiful in its simplicity, yet necessary because it eliminates decision making when it is most difficult to act rationally. Forcing yourself to plan ahead – and sticking to that plan – can eliminate much folly.
We can take this a step further. Here are some of the questions I think would be helpful:
- What’s my minimum return requirement?
- What’s the maximum position size I’d be comfortable with for this holding?
- At what rate of return would I happily be all in (at the full weighting)?
These questions should also be considered during the research process.
Let’s return to the numbers from above for an example. It seems 12% is a reasonable number for a minimum required rate of return, conservatively calculated, to start building a position (admittedly, I’ve bent on the low end of my return requirement as Mr. Market has thrown a few pitches that caught my eye). In this case, that means buying in at $100 per share.
The next question relates to the size of the position. I would be comfortable with 50% or more of my portfolio in Berkshire Hathaway (BRK.B) at the right price. There are very few companies of which I can say that (at least at valuations Mr. Market is likely to offer). Walmart (WMT), a name I’ve discussed a lot as of late, is roughly 8% of my overall portfolio, including cash. There, I probably wouldn't be comfortable crossing 15% or so. Even if these numbers are subjective, or even change over time, it’s worth having a rough idea of where you stand.
For this exercise, let’s assume your cap is 10% for “Company A” in your portfolio.
Finally, we have to determine our overall return requirement. For me, that number is roughly 15% a year (with the same confession as above). That's where I really get excited.
With those three numbers, we can set a simple guide for when to buy:
(1) Buy 2% at $100 per share, where returns are expected to be ~12% a year; (2) Buy 2% at $92 per share, where returns are expected to be ~14% a year; (3) Buy 2% at $84 per share, where returns are expected to be ~16% a year; (4) Buy 2% at $80 per share, where returns are expected to be ~17% a year; (5) Buy 2% at $77 per share, where returns are expected to be ~18% a year.
If you invested $5,000 total ($1,000 per purchase) and were able to buy at every rung, you would end up with ~58 shares and an average cost of ~$85 per share. Over five years, your expected return would be just above 15% a year (pretax).
Obviously you can tweak the numbers to fit your desired number of purchases, the maximum position size, your return requirements, and so on.
Conclusion
The math isn’t the real point of the article. Whether you use the example from Mr. Templeton (buy 100% of the position at “x”) or the example I’ve outlined, here’s the real question: why would you ever walk away from researching a company without a set buy price? If it’s a company that you would buy at some price, doesn’t it makes sense to figure that out now?
I can’t think of a good argument otherwise. If you are truly comfortable with the company and the valuation, there should be no qualms about committing to investing at the price of your choice (even if it’s 70% below the current stock price). If the thought of doing so makes you queasy, that suggests you’re uncomfortable with at least one of those two variables.
The only other answer is that lower prices alone make you nervous. This might not apply when looking from afar but only when wading through the storm. When you’re in the process of “losing” lots of money, putting more on the table isn’t necessarily the easiest thing to do.
This is entirely understandable – but it’s directly opposed to intelligent investing. Sir John understood this and put a system in place that would eliminate any need for decision making when it was toughest to do so. Most investors would greatly benefit if they followed his example.
