The above question can be framed differently as “Do I wait for next Downturn for Cheaper Valuation?”
When you are building your portfolio towards a long term sustainable wealth creation, there are multiple aspects that you need to focus on. As individual investors, it is very easy for us to get carried away with the individual stock wins. But when we look holistically, including wins and losses, then we realize who is the real winner. That’s why I say, for DIY investors, sustainability is key in portfolio management. Over the years, all the retail investors I have interacting with, most of us focus too much on stock picking, or stock selection. This is similar to what an employee does of executing blindly now knowing how it is related to overall company strategy.
The first lesson you should learn in investing is “not stock picking”, but how you can maintain and sustain what you have (safety of capital). By this I do not mean going with bonds, FDs, or government certificates. What I mean is invest in a way, where you believe there is relatively less risk of losing your capital.
One way to minimize risk is to buy cheap. Buying stocks at cheaper value will not give you 100% downside protection. But it will reduce the likelihood of your losses. OR in worst cases, it will reduce your losses. In my process, I calculate fair value which I am willing to pay. Almost always, this fair value comes very low. Such low values are, typically, seen during market downturns. The question arises:
- Do I keep waiting or continue to anticipate the next downturn?
- It may take long for next downturn?
- What about the many missed opportunities “now”? If I do not buy now, I may miss it?
- Some companies are good and hence will never be at TIPBlog’s fair valuations?
- Are current prices good enough? I do not need 50% margin of safety. I am good with 20% margin of safety?
All above questions are valid. At the same time any answer that you give could be right or wrong depending upon the context. So I cannot answer these for you. But I will try to answer this in the context of, “building my long term portfolio”.
In an earlier post, I discussed three different approaches to stock buying process. I buy stocks or add to existing position over a period of time. I do that in multiple lots. Let me discuss this will some examples.
Adding to existing position
Early 2009, I added to my existing positions in ONGC, LNT, HDFC Bank, Reliance Capital, and NTPC. When I first invested in these companies, they were at a very low price. For example, let us say, they were at 100. These companies have grown in last few years. Their profitability, cash flows, revenues, etc… have changed significantly. So it would be dumb on my part to expect that they will again go back to same valuations of 100. These could be at 200. What I need to do is look at the them again or keep them following. I need to keep evaluating and updating to see whether these companies continue to meet my buying objectives. In this case I am looking for (a) increasing dividends (b) increasing capital appreciation of 12% minimum (c) and few others qualitatively metrics. The point is my fair valuation will keep increasing and hence it can help me in decided when to add (if any).
I put such companies in my buy list when I agree that these companies continue to meet my buying objectives. But they are typically higher than even the new fair valuation that I calculated. What if the current market price is 200 or 300. So when and at what price point should I buy?
Do I buy above fair valuation? Why?
To make sense out of anything, there has to be starting reference point. In this case (or any other buying decision I use), the reference is the fair value range. My fair value calculation is more of “I am comfortable in paying that much to buy the shares”. This is not necessarily intrinsic value or book value. But buying in this range should give me positive returns, how much? I don’t know. Over the years, I have observed that it has sufficient margin of safety already built in. I hope this makes clear what it is my frame of reference. I will use Clariant and ABCIL as example to discuss making a buy decision.
The fair value range for Clariant was 361 – 432. DCF was 597. The recent market price is 600+. The fair value range is pretty narrow.
- If I get to buy in fair value range, then it is great (oye, bale! bale!). I would expect good return over time.
- In addition, the DCF is much higher than fair value range. This indicates good dividends and relatively higher premium for shares in market. In this case, buying closer to higher value of 432 should also give a good positive returns. Dividends is likely to add to my absolute returns.
- Again, do I have to keep waiting for next downturn? Probably not. Should I buy small lot with premium? how much premium? The farther I go from 432 the lower my returns would be. But I still expect to have positive returns assuming dividends and PEs continue to follow historical standards.
- For these types of companies, when I am buying shares for first time or adding to existing, I am usually open to buying a small lot at a premium of 10% to 15% of my fair value. This is because, I do not expect to sell them in near future. I would happily add to them at next buying opportunity. This level premium on a ‘small lot’ would not dent by absolute return over time.
The fair value range for ABCIL was calculated as 77 – 120. DCF was 41. Now this fair value has a pretty large range. My buy price point will have significant affect on my absolute return over time.
- If I get an opportunity to buy at 41 or below, then it great (again bale! bale!). At that point it is grossly undervalued, so I would jump in.
- In addition, buying at 41 would give very good returns. The reason for DCF being low is because dividends are almost non-existent and its stock earns low single digit premium.
- But then there is perennial question of, do we need to keep waiting for market downturn so that we can buy? Buying at 77 or above is very likely to give positive returns but percentage will vary. The higher your buy price, the lower your returns. As you buy closer to 120, the likelihood of negative returns increases.
- For a company like ABCIL which has had botched history, I would like to buy as close to 77 as possible or may be even lower. The higher I buy, I will have to tone down my expectation or be prepared for negative returns. Each individual has to decide what is good for him/her.
- For these types of companies (ABCIL, HDIL, etc) I would buy much closer to low side of my fair valuation. I would avoid buying at high side of my fair valuation. Furthermore, I am also more open to sell them when I start believing they have much higher than my fair valuation. I classify these type of companies as opportunities. They are not for long term buy and hold objectives. I will be discussing more of these types in future.
To clarify, I am not saying ABCIL and HDIL type of companies are bad. I am not saying they will vanish or give bad returns. But they do not fit into my long term buy and hold objectives. I will not buy them at premium. I am not likely to add them. I am likely to buy them only once. Finally, I am open to sell them.
Earlier post of stock buying process showed three different approaches that I use in my portfolio management process.
- Systematic fixed capital time-based investing: I had used them for building my fixed income portfolio of savings, FDs, government bonds, etc. I do not use as of today because I am fully allocated to fixed income.
- Buying in small lots: I use this actively for building my long term buy and hold portfolio.
- Buying one time: I have not been very active with this approach because it did not make sense in what I was trying to achieve. I expect to use this for opportunity portfolio. As an example, if you are following @TIPguy on twitter or TIPBlog’s Fan page on Facebook, then you may have read my update. I recently initiated a “decent” position (not a starter position) in Camphor and Allied Products.
What process do you use? Buy at once? Or Buy in lots? or Do you buy at premium?
ABCIL, Camphor allied products, clariant, fair value price, Fair Value Range, risk, stock buying process, stock picking, stock premium, when to buy