Friday, June 10, 2011

The Lower The Better

It's well understood that value investors prefer the stock price to be as low as possible before they buy in. But what isn't so obvious is what is desired of the stock once the investment has been made. The natural inclination for almost all investors is to hope that the stock price rises immediately after purchase. But is that in the best interest of the value investor? Perhaps not!

Many market participants are in it for the short-term. They cannot afford adverse price movements when the need or desire for liquidity trumps the long-term business value of the issuer. Compounding this is the fact that many such speculators invest using margin. In such cases, a market position can require additional cash infusions, which may not be available when required.

Psychologically, hanging in there when a stock price falls is also difficult. For those who hold Mr. Market in high esteem, or believe Mr. Market has deeper insight about a company than they do, a decline in sentiment from Mr. Market can invoke feelings of fear that in turn invoke an impulse to sell.

But the value investor ordinarily suffers from none of these factors. He is well capitalized; that is, he approaches every investment with the idea that he is in it for the long-term (or until price and value coalesce). He is not using borrowed money, so he has no additional cash requirements after his initial investment. Furthermore, he will only buy a company when he is convinced that he understands it; as such, the opinion of Mr. Market is unlikely to sway his own opinion of what a company is worth. The value investor, therefore, does not suffer from a stock price decline of an issue he owns.

In fact, he may benefit from such a phenomenon. A price decline offers investors the opportunity to buy more at a better price. Furthermore, a price decline over a long period allows the investor the opportunity to buy more when he is better capitalized at a later date (through the accumulation of capital through other income or other successful investments). As Warren Buffett has stated "[W]e expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up."

But even if the investor has no interest in buying more of a given position (e.g. income is negative, or a stock's position is already large relative to the portfolio), he may still benefit from a lower rather than higher stock price. This occurs when the company is repurchasing shares. If the company is getting a better deal on its stock price, then so is the investor.

A recent example of this process in action is demonstrated by GameStop (GME), a company that has been repeatedly discussed on this site as a potential Stock Idea. Shares of GameStop would likely not be so high today had the company not been able to buy back shares at much more attractive levels just months ago. Long-term investors in this company would currently be better served by a lower current stock price, as the company has more cash coming in than it needs to invest in the company's growth areas.

If a stock price in which a market participant holds a position falls, this is bad news for almost all investors. But for the value investor, it is often, counterintuitively, good news. It increases the investor's opportunity for profit and increases the stock's potential upside.

Disclosure: Author has a long position in shares of GME


Koheleth said...

Good points.

One question from an aspiring novice: what if the stock price is decreasing because of the valid anticipation of imminent dilution of the stock price? Or if the company has just made a secondary offering for whatever reason?

If you remain confident that the intrinsic value is still greater in the long term, is it then reasonable for a value investor to accumulate such a stock given that shares you already hold have now shrunk in value, at least temporarily, as a result of one or the other dilutive effects?

Thank you for sharing your insights.

Saj Karsan said...

Hi Koheleth,

I don't know of any hard and fast rules for such situations. In general, however, I would be wary of firms issuing stock at prices that are what you believe to be way lower than intrinsic value...something is amiss.