3 Bad Times to Buy a Good Stock

What is the job of a stock investor?

To me, it is simple. Firstly, an investor finds stocks that are of good quality. In this case, these stocks are the ones that consistently grow profits and maintain a healthy financial position. Secondly, an investor would accumulate their shares as long as they are cheap and undervalued.

In this article, I will share one major job scope of a stock investor that many may not be aware of. It is known as “avoiding bad stock deals”. This function alone is as important as to understanding how to profit from good stock deals today. Why?

This is because it takes more good deals to make up for losses incurred from one potential bad deal. A good stock investor must know how to protect and preserve his initial capital and investment profits.

Thus, I will list down three times when it is the worst possible time to buy shares in the stock market.

All-Time High

Have you found a stock that its price is now at its all-time high? Perhaps, you have. Let us take a closer look. Has its price increased substantially by 200% to 300% over a short span of time such as six to 12 months? Are you now tempted to go into the stock market to grab some of its shares before it rises any further?

If you are, please hold your horses. I believe in most instances that you are trying to speculate for a quick buck and are not investing. The above is a description of many lose money in the stock market. If you think that a stock would continue to rise in price after rising substantially, I think it is best to rethink as you are bound to be disappointed if the price of the stock begins to move otherwise.

You may ask, ‘But, wouldn’t it rise further?’

My reply is, ‘Sometimes it will. Sometimes it won’t.’ If you buy stocks at their all-time highs in the hope that they will rise further, you are now a participant of the greater fool theory where you hope that there are a continuous supply of fools who would buy the stocks at more ridiculous prices. The problem is, ‘What if you become the greatest of all fools?’

P/E Ratio > 30

In my previous article, I asked, ‘If I have a business that is making $1 million a year, how much are you willing to offer me to take over my business?’

If you are not sure, let me give you an offer instead. How about $30 million for the full ownership of my business? Perhaps, you are starting to compute, ‘What would my returns from investing $30 million in a business that makes $1 million a year be?’ If so, then, you are on the right direction. Logically speaking, you may reject or make a counter-offer that is lower than $30 million or at a price-to-earnings (P/E) ratio of below 30.

Today, many do not apply the same logic towards buying shares in the stock market. If you think that the $30 million offer is ridiculously high, please do not be shocked that many are willing to buy shares when their P/E ratios are substantially above 30 or worse, have prices (Ps) but no earnings (Es). This is why investors must make sure a stock is profitable and have its P/E ratio calculated before making any investment decisions.

Dividend Yields < 3%

If you are an income investor, dividend is a key part of your portfolio. Today, with market uncertainties, investments that generate stable cash flow are desirable. Thus, it is prudent for you not to ignore dividend stocks even if you intend to invest solely for capital gains. A stock that pays 6% in dividend yield is, in general, more attractive than one that pays 3% in dividend yield. This is because investors are getting more cash returns which are more predictable than potential capital gains which are less predictable.

Here is a tip. Personally, I would compare the potential dividend yield of a stock with bond coupons and the current fixed deposit rates offered by local banks. Why? I believe I should be compensated with higher returns from investing in stocks as compared to placing money in bonds and fixed deposits which are deemed to be of lesser risk. It is ridiculous for me to invest in stocks which may be of higher risk if I am getting the same returns from bonds and fixed deposits.

The three tips mentioned has proven to be useful for me to avoid buying stocks that are expensive and I hope they would be helpful for you too.

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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 Stanley Lim doesn’t own shares in any companies mentioned.