In a recent article I detailed various ways of generating income from a security like General Motors (NYSE:GM). The idea was simple: General Motors already offers a well above average dividend yield, and you could think about enhancing this income stream with potential option agreements. I also noted that the long-term owner, who happens to be a long-term net buyer as well, ought to be cheering for price declines along the way.
This notion in particular often proves to be a psychological stumbling block for a good deal of investors. Indeed, the idea influenced a comment along these lines: "No one I've ever heard of is cheering when a stock they are long sees its value drop by 25%... that's just absurd."
On the surface this type of comment may appear reasonable enough. We invest to make money, so it seems natural to assume we'd rather see higher as compared to lower share prices. Yet the timing is important and can have a tremendous influence on how you deal with price fluctuations along the way. I'll show you what I mean.
There are five basic scenarios that I would like to detail with regard to seeing a large decline in the share price of a company you partner with. For illustration let's suppose that one year or less is considered "short term" and two years or more is "long term." Ideally I like to think about "long term" as decades, but a couple of years will work for this demonstration.
The first scenario is that of a short-term speculator. You buy today and hope that someone else will come along and purchase your shares at a higher price tomorrow. Sometimes literally tomorrow, sometimes next week or month; you get the idea.
We'll use General Motors throughout this article as a lasting example. As I write this, the share price is around $29. For demonstration, we'll suppose that the price drops to $25 in the short term. Now for the short-term speculator, this is very bad news. You can't make money by buying high and selling low. As a result of other people's pricing bids, your strategy has been thwarted. Indeed, this person would not be cheering.
General Long-Term Owner
Of course not everyone is a short-term speculator. And note the term "speculator," as Warren Buffett would have it: "We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic.'"
Instead, you could have a long-term mindset whereby you may notice short-term fluctuations, but your focus is on the productivity of the business and the long-term value that it can provide.
Should a long-term owner experience the same price drop from $29 to $25, this wouldn't disturb them nearly as much as the short-term speculator. Actually, as we're about to see, it's something that you ought to be rooting for.
For the short-term speculator, you buy at $29, the price goes to $25 and that's it. The ride is over. Thanks for playing, better luck next time. For the long-term owner, the ride keeps on going.
Long-term ownership in stock is very much like owning an apartment building or a farm. If you bought an apartment building for say $29 million, I could come to you and offer $25 million tomorrow or in a few months. This doesn't mean that you have to take the bid. It's just a liquidity offer -- the price you could sell to me, if you so desired, at this moment.
The long-term owner is much more focused on the quality of the business, whether or not its improving and the value that it can provide over the years. Aside from dealing with the psychological effect of someone bidding below your cost basis, the long-term owner is not affected in the same way that a short-term speculator would be. There's no action that needs to be taken if someone offers $25 for your General Motors shares instead of $30.
The long-term owner, in general terms, ought to be indifferent as to whether other people bid $25 or $30 if you have no intention of selling at either price.
Long-Term Buyer, "Fresh" Capital
Actually that's not perfectly accurate. If the long-term owner is not buying more shares and has no plans to sell in the short term, then they would be indifferent. However, the long-term owner is apt to be a long-term net buyer in one of three ways.
First, quite literally you could buy shares today and then again in the short or long term. For illustration, let's suppose that you're going to buy $1,000 worth of General Motors today and $1,000 worth one year from now.
Naturally we don't know what the future share price will be, but to continue with the example, I'll give you some alternatives. Today the share price is around $29. In two years let's say the share price is $40. After the first year, would you prefer to buy your second batch of shares at $25 or $35?
The answer is obvious -- the lower share price allows you to purchase more shares, buy a larger portion of the business and generate a greater amount of future dividend income. The answer is obvious, but the instincts of a good deal of investors often get this precisely backwards. Even when buying more shares, the general investor community treats higher prices as "good" news and lower bids as "bad."
With your first $1,000 you can purchase roughly 34 shares (using round numbers). If the future share price was $35, your second $1,000 could purchase 29 shares, giving you a total of 63 shares. During this time, you would collect ~$148 in dividends (assuming the same quarterly payout) and your stake would be worth ~$2,520.
Alternatively, if the share price was $25 instead of $35 after the first year, your second $1,000 could purchase 40 new shares, giving you a total of 69 shares. Over this period, you would collect ~$157 in dividends and your stake would be worth ~2,760.
And by the way, this works the other way as well. If the future share price was say $20 instead of $40, your stake would still be worth more in the second scenario.
The point is that sometime in the future (whether two years or 20 years) shares of General Motors are going to be worth X. Before that time comes, if you believe in the business and continue to purchase shares, you'd much prefer to be buying at lower rather than higher prices.
Long-Term Buyer, Reinvestment
Some might suggest that they are not adding new capital and the dividend reinvestment doesn't add up to much. Yet here again, a lower price is a benefit to the long-term owner.
In keeping with the above example, after the first year if you were able to reinvest at $25 instead of $35, you could add an extra 0.6 shares per $1,000 invested. In turn those extra shares would be turning out an additional $0.90 in annual income and $24 in value.
It's not a huge difference, but there are two important notes that come into play. First, it compounds over time. The small benefit starts to become a larger and larger benefit down the line. Second, it's still an advantage. Whether the future price is $10 or $50, you're always going to be better off owning more shares -- extra shares that were possible as a result of lower, rather than higher prices.
Long-Term Buyer, Share Repurchases
The remaining holdouts may suggest that they are not a net buyer because they are not adding new capital and they choose to reinvest the dividend payments elsewhere. Yet we're not done quite yet. Even if you don't add a dime to the holding and collect all of your dividends in cash, you could still be a net buyer through share repurchases. The company is taking a portion of your earnings claim and using it to buy out past partners, thereby increasing your ownership claim in the business.
Here again, it's lower rather than higher prices that benefit you. I'll keep the example straightforward. General Motors announced in January that it had expanded its share repurchase program up to $9 billion. The question that results is not a complicated one: as a long-term owner, would you prefer that General Motors use those funds to buy out partners at $25 or $35 per share?
Once more the answer is obvious. Aside from some benevolent feeling for your departed shareholder, you don't want the company to use more money than it has to buy out partners. This particular illustration could be the difference between whether or not an additional 100 million shares are retired.
It's an odd phenomenon -- cheering higher prices even as you buy -- that occurs largely in the investing world. As a group, we don't make this sort misstep with everyday purchases. If bananas are selling for $0.49 a pound and you deem that a good price (and you like bananas), you buy them. What you don't do is get to the cash register and hope to pay $0.60 a pound. Or when you're driving along and see gas for $2.20 a gallon, you don't root for it to hit $2.40 before you finish pumping.
Yet for some reason, a great deal of investors -- even those who will continue to be net buyers for years -- root for higher prices. And here's the thing: if you really wanted to buy at a higher price, that sort of thing would not be hard to arrange. If you're buying General Motors at $25, but would rather see the share price go to $35, the seller will gladly accommodate you. It's lower prices that you have to convince people to agree to.
One more example. It's analogous to if you were buying a second investment property. Let's say that you bought your first one for $100,000 and you're happy with the cash flow and returns that it provides. Here's this other one that is quite comparable to yours selling for $90,000. The logical thing to do would be to buy it at $90,000 or else bid at an even lower price. And most investors would follow this route.
When you're rooting for stocks to increase as a net buyer, it's the equivalent to seeing the $90,000 price tag for an investment property and hoping to pay $110,000 to make your past purchase look better at that moment in time. The seller will gladly accommodate your request, but it does you no favors as an investor.
The psychology of the short-term speculator I understand. I don't agree with it, but I get it. The share price needs to increase and increase fast. And it would be absurd to root for a lower price. Yet for the long-term owner, who is very likely to be a long-term net buyer, rooting for a lower price is quite logical and indeed could provide a great benefit down the line.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.