With news flying everywhere and frequency trading, the price of a stock can move up or down without any justification. For a long-term investor, it helps to ignore the noise and buy a stock after it has a substantial pullback. Moreover, it helps to choose to buy a company that is known for its stability and reliability in making earnings.
We all have certain rules that help us make the decision of buying a stock. The rule I'm about to talk about easily applies to any fundamentally sound company that has a beta of around 0.5. However, to make it simpler to understand, I'm going to use Coca-Cola (KO) as an example.
Imagine I've been looking to buy KO for some time now, but I wanted to wait for a substantial pullback before getting in, so that my future returns are improved.
It comes down to defining what "a substantial pullback" is. Because KO has a beta of 0.51, I set the substantial pullback at 10% from its 52-week high. For readers who may not know what beta is, here is a definition from Investopedia:
beta - A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
So, if the beta of a stock is 1, it moves more or less to the general market. In this case, if the general market goes up by 1%, KO will go up by about 0.5%. If the general market goes down by 1%, KO will go down by about 0.5%.
Rule of 10% Pullback on a Reliable and Stable Company
A 10% pullback from KO's 52-week high would be $36.6
using the formula:
52-week high * (1 - pullback-percentage)
= $40.67 * (1 - 0.1) = $36.6
That's the price I want to get in for KO.
The rule keeps my patience in check, so that I don't get in on small pullbacks.
Wait, what about the Opportunity Cost?
Some people argue that there's an opportunity cost in putting cash aside while waiting to get in on a stock. That is if investing for the long-term, you wouldn't be too picky on the price as long as the company is fundamentally sound. However, the price you buy highly determines the future success of this investment. It is precisely that we're planning to hold for the long-term that we want to wait for a significant pullback on a stock before getting in.
For example, I really did want to get some KO shares when it was around $80/share before the split. Because at the time, it was near the 52-week high, I didn't get some. This is partly because there will always be some news, some macro-economic factors, some negative sentiment that would cause substantial pullback on a stock or the market as a whole, while individual company fundamentals haven't changed. So really, there's no rush in jumping into a stock.
If I didn't use the rule of a 10% pullback, but really did buy KO at $80, I would be starting with a 2.55% yield-on-cost instead of a 2.79% yield-on-cost. (I would have gotten in on some KO shares last Friday with this rule.)
What about the opportunity cost of not buying KO in July 2012 when it was at $80 ($40 after the split)? I would have missed one dividend. And that is a small opportunity cost given that I'm planning to hold KO for the very long-term and that I have now started with a higher yield-on-cost.
Dividend Growth Projection
Dividends (to be) earned is one way of determining the investment's success, and it's essential to consider for a dividend growth investor. Let's see how the 2 investments would perform using yield-on-cost as the metric if KO were to continue raising its dividend year-by-year according to its 5-year average dividend growth rate of 7.9%.
The above table shows the yield-on-cost for 20 years. Obviously, getting in on KO at the lower price costs us less while getting the same number of shares so that we have more cash for other purchases. And obviously, the yield at the lower price is always higher.
Taking the simple example of buying 50 KO shares at $80 before the split (i.e. it'd be $40 after the split with 100 shares), or ~109.28 shares at $36.6 after the 10% pullback, after 20 years we would have gotten a total of $4616.34 for buying it at $40 or $5044.7 for buying it at $36.6. That is 9.28% more in dividends!
What if KO goes further down?
Certainly that can come true, but we can't stay on the sidelines forever. And for a reliable and stable blue chip dividend grower with ~0.5 beta like KO, I would certainly start scaling in on any 10% pullback.
Coca-Cola's Friday closing price is $36.56, which is below the 10% pullback based on this rule. I would add to my KO position here if I have the funds.
If you don't already have a similar rule that you use for your buying process, I certainly encourage you to add this rule to it and apply the 10% pullback rule to companies you want to get in on that are fundamentally sound and aren't very volatile.
Disclosure: I am long KO.