When is the best time to buy shares?

Find out the triggers for share investment.

When is the best time to buy shares? Do you insist on a 20 per cent safety margin across the board? Maybe you’re prepared to pay a little above today’s value because you believe the future value of the business is likely to be materially higher.

Whatever your approach, be consistent. It’s when investors deviate from their investment approach that trouble can occur. Also remember that you won’t make money on every trade. When it comes to investing, not losing money is just as important as picking the winners.

The very best stocks often trade at premiums to what their businesses are actually worth. Woolworths (WOW), CSL Limited (CSL) and Cochlear (COH) are just a few examples.

Take advantage of market corrections

Smart investors buy shares in great quality stocks when the market is telling them otherwise – during big market corrections – when the baby is being thrown out with the bathwater. Investors who braved the chaos of the GFC, IT wreck and the 1987 crash, and bought shares in top quality businesses during these times have laughed all the way to the bank.

The problem is that these are such rare events and you can’t always wait for them to come along.

Find top quality stocks to watch

Some investors will undertake fundamental research first, then overlay technical strategies to time their entry and exit, and this is a valid strategy.

An alternative strategy is to focus on building a portfolio of stocks that are of significantly higher quality (and buying their share at the right price) than the quality of the stocks in the broader indexes that you are seeking to beat.

With your watch list full of top quality stocks, your focus now shifts to paying a rational price.

Work out your Safety Margin

That’s where safety margin comes into the equation. Safety Margin represents the difference between the intrinsic value of a company and the share price. The bigger the discount, the bigger the bargain.

Is there a ‘right’ safety margin? As a general rule, professional investor Russell Muldoon looks for at least 10 per cent for industrial businesses and 20 per cent for resources.

Be flexible

Warren Buffett famously said he’d rather buy a wonderful company at a fair price than a fair company at a wonderful price.

Cochlear has never traded below value. In 2008, 2009 and again in late 2011 it came close. Focus on the wonderful companies first – the ones with bright prospects – and don’t be concerned if the share price is 5 or 10 per cent above what the intrinsic value is today.

There aren’t a lot of top quality companies listed on the ASX, and even less trading at prices less than what their businesses are worth.

If you find a great business, and are planning to remain an owner for five years or more, will paying an extra 5 or 10 per cent today really matter if your timeframe as an investor in the business is over 5 or 10 years?

When is the best time to sell shares?

Most investors are less confident about locking in their profit by selling.

As a value investor you intuitively understand the importance of buying quality stocks with a good underlying business model when they’re trading at a discount to their intrinsic value. Everything being equal, the greater the discount between price and value, the more compelling the reason to buy.

The opposite is equally true. When the discount between price and value disappears, you may need to sell. Most investors are less confident about locking in their profit by selling.

Reasons to consider selling

Rather than agonising over selling early (as opposed to the very top), as a value investor your main goal is to maintain a portfolio of underpriced (quality) stocks most likely to outperform at minimal risk.

It’s true; the art of selling shares is considerably less predictable than buying. However, by identifying key trigger-points to prompt a timely portfolio review, we have provided you with some guiding principles for selling down a stock.

Let’s take a look at the key reasons why you might consider selling a stock down within your portfolio.

Price eclipses value

One of the cornerstones of value investing, championed by leading investor Warren Buffett, is the knowledge that a company’s share price cannot run ahead of its underlying performance forever. In other words, the share price and the company’s intrinsic value are destined to eventually converge.

The closer a company’s share price gets to its intrinsic value, the greater the risk of holding the stock. And the more the share price exceeds a company’s intrinsic value, the greater the argument for selling down. Whether you exit completely depends on your outlook for the stock, and any future upside to current valuations.

Here are some examples of share prices rising well above value and warranting a sell down.

Ten Network (TEN)

Since 2005 the underlying value of Ten Network (TEN) has declined, along with the price. And while the price tracked the underlying value, it has always been higher.

Share Analysis Line chart plots TEN’s intrinsic value and share price

Webjet (WEB)

Webjet (WEB) is another example of a company where the share price rose well above value. In fact it was also higher than 2015 forecast estimates. WEB hit a high of more than $5.20 in April 2013. Its share price retreated to $3.90 in early June 2013 and has since risen back to around $4.50.

Share Analysis Line chart plots WEB’s intrinsic value and share price

Share Analysis Line chart plots WEB’s intrinsic value and share price

So when the share price runs ahead of value, don’t be too greedy and don’t rely on hope.

Cut and run

The same can be said when the share price and value are seriously uncorrelated. Setting aside chronic poor performers, it’s not always immediately clear why you should sell a stock, especially if it’s a former share market darling or has attracted investors due to its sheer size, so here are some important tips.

Remember, stocks that find themselves significantly underpriced have typically become that way for good reason: bad management, business performance, loss of their competitive edge. These factors result in declining intrinsic valuations and future growth that is less promising. In the long run, return on equity and (ROE) falls, along with cash flow.

Examples of quality companies that have suffered from deteriorating business performance and/or value include Leighton Holdings (LEI), Boral (BLD) and QBE Insurance.

In the case of Boral, the company’s return on equity (a strong measure of profitability), has gone from just under 20 per cent in 2004 to 3 per cent for the 2012/2013 financial year. Despite declining earnings, the company continued to pay a dividend. In 2010 BLD reported negative NPAT of $18.7 million, yet paid out dividends of $42 million. By 2012 the company was in a Funding Gap of almost $900 million. Unsurprisingly, since 2006 BLD’s share price has more than halved.

Leighton Holdings (LEI)

The recent history of one of Australia’s largest internationally operating businesses, Leighton Holdings, paints a similar picture. Between 2004 and 2009 LEI’s ROE rose from 17 per cent to almost 40 per cent , triggering a corresponding hike in the share price from below $10 to over $60.

But by 2011 LEI’s ROE dropped (well below the preferred 25 per cent) to 9.21 per cent, and the share price fell to around $17. Based on its December 2012 full year results, LEI was rated B2 by Share Analysis. Its shares were trading at around a 20 per cent discount to the current intrinsic value estimate of around $21, which was forecast to rise to more than $22.50 by 2015.

Share Analysis Line chart plots LEI’s intrinsic value and share price

Share Analysis Line chart plots LEI’s intrinsic value and share price

QBE Insurance (QBE)

QBE is another example of the oft-quoted truism, ‘price eventually follows value’. In 2007 QBE reported EPS of $2.26. In 2012, QBE reported EPS of $0.73. Over that same period NPAT declined by more than $100 million, while debt increased to over 25 per cent of the company’s total equity.

From a peak of more than $31.78 in 2007, Share Analysis estimates QBE’s underlying value has fallen by around 60 per cent, to $6.23 (as at 30/12/2012). Like LEI, Share Analysis forecast QBE’s intrinsic value will rise over the next two years.

Share Analysis Line chart plots QBE’s intrinsic value and share price

Share Analysis Line chart plots QBE’s intrinsic value and share price

Oroton Group (ORL)

Then there are stocks like Oroton Group (ORL) and David Jones (DJL) where the future growth, due to a myriad of factors, no longer looks promising.

Share Analysis Line chart plots ORL’s intrinsic value and share price

Share Analysis Line chart plots ORL’s intrinsic value and share price

As you can see from the above examples, the trick is to take these smouldering time-bombs out of your portfolio before they do greater damage, and use the funds to buy superior investment opportunities elsewhere.