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Chapter 11 — WHEN TO BUY STOCKS
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WHEN TO BUY STOCKS

WHEN TO BUY STOCKS

While stock prices are technically based on the current financial situation and potential outlook of companies, the fact is that investor sentiment is really what drives short-term fluctuations in stock prices. Considering most investors cannot predict the future, a lot of decisions on whether to buy or sell are based on that individual’s best guess of which direction the price is going. Below are some ways to identify when a stock is a buying opportunity.

when to buy stocks

UNDERVALUED STOCKS

There are two common instances of a stock being under-valued. The first one is when a stock “goes on sale” and the second is when the stock of a company is generally undervalued based on its business outlook.

Generally, a stock can go on sale during a market downturn. For example, in 2008, when the market crashed, many stocks even unrelated to the financial crisis were negatively impacted. As a result, most investors became pessimistic and avoided investing any more money into the market, despite the opportunity to snap up great companies at unreasonably low prices. It is here that some major returns can be generated from companies that will most likely survive the hard times.  

Investors can also become pessimistic on a stock without a general economic depression. For example, a disappointing earnings report may send prices tumbling, but if the company still has a promising outlook for the future, this may present yet another lucrative buying opportunity.

Sometimes, however, a company can be undervalued on its own. Generally, this is determined by looking at the company’s future prospects. A key way of doing this is to look at a company’s forecasted revenues and expenses, which is known as conducting a discounted cash flow analysis (literally taking a company’s future cash flow and discounting them back to the present - what that future money is worth today). Theoretically, the sum of these values is their price target. As such, if the current price is under this target, then this company is likely a good buy.

Another good way of determining if a company is undervalued is to compare a stock’s price to earnings ratio versus direct competitors, which can help you determine if the company is cheap compared to its rivals. Oftentimes, if you see a big jump in the price of one company in an industry, then it’s likely that its rivals will eventually catch up unless they truly have a distinct and sustainable competitive advantage that makes them truly unique.

INVEST IN COMPANIES YOU LOVE

Do you ever find yourself enamored by a product or a brand? These oftentimes are great buying opportunities because more likely than not, you’re not the only one that feels that way. Typically, companies that have a loyal following tend to perform well, even if their current market price may not be considered “undervalued”. The fact is that great companies find a way to innovate and create great products, which in turn results in strong, consistent growth. In the end, strong leaders with great vision will make your investment worthwhile.

‘TIS THE SEASONS

Sometimes you can find tactical opportunities to purchase based on seasonality or news cycles. For example, tech stocks like Apple tend to see strong price appreciation building up to major announcements, product launch events, or holiday seasons. If you have high expectations for that product release or consumer’s buying power, then you may want to get in a couple of months earlier before the media starts buzzing, thus driving up the stock price.  

DOLLAR COST AVERAGING

Sometimes the stock of a good company falls, and if you hold shares in that company, then you may want to consider buying more. This is what is known as dollar cost averaging. For example, in January you bought 10 shares of ABC Corp for $100 with an expected return of 20%. Due to economic turmoil and market volatility, the shares fell to $80 two months later, making you a bit concerned, but the fundamental outlook of the company hasn’t changed. You still believe that the company’s true value is north of $100, so a good strategy would be to buy more shares at $80. If you buy 10 more shares, then your cost basis, or the average price paid for the stock, now becomes $90 (the original 10 shares @ $100 + the 10 shares @ $80). Now, when the stock increases to $120, instead of making a 20% return or $20 per share, you’re able to make 33% return or $30 per share. Not a bad strategy if you truly believe that the company can deliver on your original expectations.

ECONOMIC CONDITIONS

How the overall economy is doing can determine which sectors or companies to invest in. For example, when the economy is coming out of a recession and is heading towards brighter pastures, then companies like retailers that sell products to consumers may become attractive because consumers spend more when their confidence in the economy is high. Investments that do well in good economic environments and poorly in back economic environments are called cyclical businesses. Alternatively, those that perform well in down markets are referred to as counter-cyclical. Companies in the utility sector tend to be considered counter-cyclical because they offer products that would be considered a basic necessity, and therefore maintain their revenues consistently irrespective of the market environment.

RAW MATERIAL PRICE CHANGES

Every company that provides a product has input factors that go into creating that product, whether it’s coffee beans for Starbucks or labor costs from a consulting firm. Therefore, when the price of raw material changes by a notable amount, then this creates a buying or selling opportunity (e.g. Buying if the input got cheaper and Selling if it got more expensive). So, the next time coffee bean prices go tumbling, then Starbucks may be a great buying opportunity (unless for some unlikely event that the civilized world decides they can all of a sudden function without their daily caffeine fix).

INDUSTRY TRENDS

We live in a technology age. A product revolution one day can become obsolete the next. Industries meanwhile are being built around these revolutions all the time. A great example of this would be networking and communication devices. Cisco came into the picture, defining an industry, and subsequently making investors a lot of money. Generally, if an industry is on the rise, then competitive companies in that industry will also be on the rise, thus making for an attractive buy.

PATIENCE AND THE ABILITY TO HOLD

Additionally, an important factor when deciding on purchasing a stock is your ability to keep that money invested. Oftentimes, a stock may reach its full growth potential over a long period of time, whether it be next month, after the next earnings call, or even next year. Regardless, you need to be ready for this eventuality and should only be ready to invest if you don’t need the money immediately and are ready to be patient. The shorter time you can be without that money, the less risk you should take and, subsequently, you should expect a lower return.

DO YOUR OWN HOMEWORK

It is important to do your own homework. Relying on analyst opinions is a great start, but it is important to form your own opinions by combing through the annual report (a quick tip is to read articles commenting on those reports), recent news releases and product announcements. This can be the difference between a good and a great investor so be sure to form good habits early on. Don’t forget, when looking at any company, it is important to assess how confident you are in the company’s team and products before making any investment decision.

Quiz

What should you look at when buying a stock?

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0/76 (0%) Correct
  • 1
    a. The company's valuation
  • 2
    b. Your ability to be patient
  • 3
    c. Industry trends
  • 4
    d. All of the above.
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