It’s an open secret that the way to make money in stocks is to buy low and sell high.
What most investors don’t understand is there are two distinctly different ways of buying low. One method leads to huge profits with a high margin of safety. The other usually leads to frustration and big losses.
So let’s take a closer look at both…
I can’t count the number of times investors have told me they lost a bundle “buying low.” Here’s a typical example:
“I didn’t buy Amalgamated Widgets until it had plunged from $50 all the way down to $15. It was at the 52-week low. No one had bought it cheaper all year. Yet I still got spanked. A week later it dropped below $10. A month later it was under $5. Now… well, I don’t even want to think about it.”
This is where so many novice investors go wrong. They think if a stock is cheaper than it used to be, it must be a bargain.
Know the Problem
Not necessarily. Remember, when a stock suddenly falls out of bed while the broad market is flat or rising, something is clearly wrong at the company.
Maybe sales are worse than expected. Maybe market share is down or profit margins are being eroded. There’s a reason a company’s shares have suddenly done an about-face, and you need to know what that is before you risk your hard-earned capital.
Even once you know the problem, “caveat emptor.” Yes, some companies hit the skids and eventually come roaring back. A good example is Green Mountain Coffee Roasters Inc.
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), which plunged last year on news of an SEC investigation into its accounting then soared 300% when nothing was found amiss.
But there are plenty of other stocks that go nose down and are never able to pull out of it.
Beware Value Traps
The reason is obvious to anyone who has ever owned or managed a business. Many companies find a profitable niche and work it for all it’s worth. But over time, things change. New competitors arise. Market conditions change. Customer tastes evolve.
We’ve all seen this happen with local restaurants that are wildly popular one year and going out of business the next. Once a company loses its mojo, it can be difficult to get it back.
That’s why you have to be very careful, very smart and very patient if you are going to buy “fallen angels.” Just ask Bill Ackman, the hedge fund manager who recently took a huge loss on J.C. Penney Co. Inc.
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) just two years after taking a similar beating in Borders Group. Both stocks were value traps.
So what is the right way to buy low? When the whole market
hits the skids, as it did in the recent financial crisis. That’s when you can buy with confidence, knowing that fear is causing investors to behave emotionally rather than rationally and great companies are thrown out with the bathwater.
The 2007-2009 stock market meltdown was one of the great buying opportunities of our lifetimes. And you didn’t have to be a financial genius to take advantage of it. Thousands of companies were selling at fire-sale prices. The Dow has more than doubled from its March 2009 lows and many individual stocks have risen threefold or more.
Bulls Are Back
Of course, we’re back in a bull market again. That means you have to be vigilant. Fight the temptation to look for companies that are getting beaten up. That’s not the way to buy low unless you are a sharp analyst with a long time horizon.
Instead, look for companies that are rising but still selling at an attractive valuations relative to sales, earnings, dividends and book value. That’s what gives you not only excellent upside potential but a high margin of safety as well.
In short, there was more than a little truth in the market advice comedian Will Rogers used to give: Just buy stocks that go up.
“But what if they don’t go up?” someone asked.
“Then don’t buy them.”