One of our readers recently asked us a question about when to purchase a share. Specifically, he asked: “Assuming I have found a company with a competitive advantage, experienced team of directors and managers, ratios are healthy and growing from year to year but is overvalued. There is no telling when the prices would come back down. It could be the next year or the next 5 years. It could also go further up. In such a case, should an investor still buy bits along the way by way of dollar cost averaging or sit out anyways until the…
Specifically, he asked:
“Assuming I have found a company with a competitive advantage, experienced team of directors and managers, ratios are healthy and growing from year to year but is overvalued. There is no telling when the prices would come back down. It could be the next year or the next 5 years. It could also go further up. In such a case, should an investor still buy bits along the way by way of dollar cost averaging or sit out anyways until the intrinsic value hits below the current share price?”
Thank you for the wonderful question. I’m sure many of us have wondered the same thing. Personally, I feel that sitting patiently on the sidelines while waiting for the share price to come below intrinsic value is the best thing to do. I would rather wait patiently and buy only when the intrinsic value is above the share price with a margin of safety than buy an overvalued stock and see the price crash-and-burn. Warren Buffett said that not losing money is the most important in investing. Even now, there are a few companies that I really like that have a sustainable competitive advantage, great growth, healthy balance sheet and cash flow but the valuations are a tad too high for my liking.
I mentioned buying only with a margin of safety built in. A margin of safety is the difference between the intrinsic value of the business and the share price. The bigger this difference, the higher the margin of safety that is built in. A margin of safety provides a slight room for error. No one can analyse a business perfectly and we may have overlooked certain aspects of the business. Having a margin of safety cushions us from those mistakes.
Meanwhile, while waiting patiently for the market to reward us with a cheap valuation of the business we are eyeing, I feel that socking up cash is the next best thing to do. The cash, when deployed during a market crash, will more than make up for the “lousy” returns. For example, during the sub-prime crisis, companies such as Raffles Medical Group (SGX: R01), Super Group (SGX: S10) and SIA Engineering Company (SGX: S59) had plunged around 64%, 64% and 62% respectively from their respective peaks in 2008. They have since recovered to hit gains of approximately 382%, 413% and 156% respectively, to date. If we do not have cash to take advantage of such market folly, we would be kicking ourselves in the butt.
Do bear in mind that the share price of the company you are interested in may go up in price during the time-frame that you are not vested. Remind yourself that Mr. Market is getting euphoric and that in the short-term, the market is a voting machine.
Having patience is one of the most important aspects to be a good investor. Warren Buffett once sat out of the market for four years from 1969 to 1973 as he had nothing to buy. In 1973, when there was a market crash, he put the cash to use and made four times his money. According to the National Bureau of Economic Research, a market crash occurs on average of once every five years. Therefore, being patient really pays and huge opportunities will be presented during those times. Only thing is that, do we have enough cash to take advantage of Mr Market’s depressive mood?
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.