How Do You Know When to Buy Stocks?

Includes: ACF, BRK.A, BRK.B, LUK-OLD
by: Ye Cheng Yuan

Buy low, sell high.

It's obviously good advice. In practice, it's not as easy as it sounds.

How do you know tomorrow the price will not drop another 10% or 30% for that matter? If you bought today with all the cash at hand and it drops another 50% tomorrow, no amount of self-kicking would relief the pain inflicted.

Take Leucadia (NYSE:LUK-OLD) for example. It first revealed its stake in AmeriCredit (ACF) early in January 2008. By May, it has acquired approximately 26% of outstanding shares at an average price of $13/share. When Fitch affirmed AmeriCredit's negative outlook, its shares promptly went into a free fall and didn't stop until it lost about 37% of its market cap.

All the while, Leucadia stayed on the sidelines. Recently, Leucadia finally bought the last 4% of the outstanding shares (at an average of $7.63/share), hitting the maximum of outstanding shares it can own based on its agreement with AmeriCredit. No one could have anticipated that significant a drop.

So that begs the question, "How do you know if you are buying at the bottom?" The truth is nobody knows. To quote the Fidelity Magellan Fund phenom, Peter Lynch,

When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30. You just don't know when you can find the bottom.

The best defense against such devastating drops is to ensure you have a big margin of safety. Sure, even with a big margin of safety you might still face a huge drop after the purchase. However, if you are confident about your analysis, you can take comfort in the fact that the drop is nothing but a temporary paper loss. Given that we don't know the bottom, how much should we invest when we have sufficient margin of safety? Should we go all out? Should we hold back some just in case it drops further?

Looking at Leucadia's transactions, it doesn't seem like there's a formula to determine how much to invest when you hit a certain price point. I'm sure Ian Cumming wished he could have bought all the shares at a 37% discount. Clearly, he didn't expect the price to drop that much. Had he known, he would have waited.

Institutional investors like Leucadia and Berkshire (NYSE:BRK.A) (NYSE:BRK.B) usually buy shares in chunks instead of all at once. The sheer volume of shares being bought would cause the price to jump. When you are buying a $50 million stake, an increase of 1% in price will cost you an extra $500k. Not exactly chump change.

For us individual investors, the lack of such buying power is in fact a blessing in disguise. The volume we deal with is so small it barely affects the price. So, we don't have to buy in chunks. But, could buying in chunks help reduce the average cost? Buying in chunks is a double-edged sword. It can only reduce the average cost if the price is falling. If the price moves in the other direction, it ends up increasing the average cost.

Also, don't forget the frictional cost of commissions. The greatest risk of buying in chunk is you may not realize the price is already at its bottom. When the tide rises, it may continue to rise and never return to that lowest price point. And 25 years from now, you would spend the rest of your life lamenting to your friend how you could have been a billionaire had you bought that stock with all $10,000 you had.

Buying stocks is really a tough decision. Spend all your cash and you risk not having cash to spend if the price drops further. Spend too little and you risk missing the chance to dethrone Warren Buffett on the Forbes 400 Richest.

Looking at both sides of the coin, the risks may seem well balanced. The truth is the former is less painful should it materialize. In fact, Buffett has made the mistake of the latter and considers it one of the biggest mistakes in his investment career. He admitted sucking on his thumb when Wal-Mart (NYSE:WMT) was selling on a discount back in 1999. He estimated the error cost him $8 billion. If you miss the ride, the inflicted pain could get worse as the price rises. On the other hand, if you bought as much as you could, there is a floor for how much the price could fall.

So, to avoid future heartaches, I would rather buy with all the cash at hand when the opportunity presents itself. When the price falls further (yes, this has happened to me numerous times), I usually find that I have some cash at hand because like everyone else, my income produces some incoming cash flow. So I buy more. Am I completely off base here? What is your strategy in buying stocks?

Disclosure: No positions in the stocks mentioned