The ability to identify value stocks is undoubtedly an important skill for any investor to have. However, there is another aspect to investing that is perhaps less often talked about - the actual process of buying and selling stocks.
Once you have found a company that you consider to be undervalued, how do you go about building up a position? Do you spend all your allocated cash in one go, or do you wait for the stock to get cheaper? How do you know when to sell?
In his book "Margin of Safety," value investor Seth Klarman (Trades, Portfolio) provides some advice on these topics.
How to buy
All investors need to be comfortable with the short term fluctuations that will inevitably affect the valuation of their portfolio, but this is especially true of people who are investing in underpriced securities. In almost every case, investors in cheap, beaten down businesses will have to endure some period of further price decline.
Klarman believes that investors should avoid taking a full position (the maximum commitment they are willing to make) with one single trade, instead leaving capital in reserve to "average down." Thus, if the stock price continues to fall, you can buy more, bringing your average per share cost lower. Furthermore, this practice can help you identify and reject investment ideas that you don’t really believe in:
“Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices. If prior to purchase, you realise that you are unwilling to average down, then you probably should not make the purchase in the first place.”
How to sell
What about the other side of the investing coin? How do you know when to sell a stock? After all, a key tenet of value investing is that it is impossible to put an exact price target on a company; only an approximate range is appropriate. Klarman sums up the difficulty with knowing when to sell by pointing out that:
“Some investors create rules for selling based on specific price-to-book value or price-to-earnings multiples. Others have rules based on percentage gain thresholds; once they have made X percent, they sell. Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell. None of these rules make good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price.”
Klarman believes that if you can’t decide when a stock in your portfolio has become appropriately valued by the market, then you probably shouldn’t have bought it in the first place, and that you were probably speculating when you did so.
Read more here:
- Jack Bogle: Beware of Excess Optimism
- Warren Buffett: Know When to Cut Your Losses
- Jack Bogle: Don't Attribute Certitude to History
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