Are low prices a justification to buy?

Should I use stock prices in my screen?

I read several blogs on investing. I have noticed that several authors have been talking about purchasing a stock that has gone down in price over a certain period of time. It looks like looking at a list of stocks at a 52 week low or looking at biggest losers year-to-date has been a criteria to some investors. I am going to explore this idea in this article, and share my ideas on the topic.

Before I go any further, I want to mention that I am looking for companies that I can purchase at an attractive entry price, which can grow earnings and dividends above the rate of inflation, and can generate a decent yield in the process for me.

At first, it actually seems like a nice idea to look for companies, which have declined in price. This could be one way to identify shares that could be theoretically cheap. We all know that a company’s cheap stock price can always get cheaper in the process. Of course, a stock price that has gone down presents an opportunity to buy more shares for the same amount of capital. In addition, by buying more shares, the investor can end up purchasing more dividend income in the process.

So this sounds like a win-win ( win) at first glance. Why am I writing an article about it?

Well, the problem with just looking at price relative to its high for the year or its close from the previous year is that price itself doesn’t tell you the whole story. What matters is price in relation to fundamentals, as long as those fundamentals are growing.

Investors need to have a way to systematically evaluating fundamentals using relevant information, and use this in their model in order to come up with a decision of whether a stock is undervalued or overvalued. However, if there are some changes in fundamentals, then a low price could be justified. In addition, if fundamentals have improved, a higher price might be justified.

For example, back in 1984, Coca-Cola (KO) earned $0.10/share. The stock traded between $1.02 and $1.38/share that year. The share price today is close to $40/share. This increase is justified, because earnings per share have grown to over $2/share in 2014. This growth in earnings per share has also enabled the company to continue raising its dividends for 53 consecutive years.

In another example, in early 2015, many shares of oil and gas companies looked very cheap based on the earnings from year 2014. The problem was that many investors were ignoring the fact that oil prices had declined, and therefore the earnings from year 2014 ( which was characterized by generally high oil prices) should be adjusted downwards. Prices on shares of Chevron (CVX) and Exxon Mobil (XOM) had declined a little from their highs, but they were not a good value yet. This is because the underlying fundamentals had deteriorated faster than share prices. Therefore, in early 2015 the shares were overvalued, despite the fact that they had declined in value. I bought some ConocoPhillips (COP) in early 2015 and some Exxon Mobil (XOM), but then mostly stopped my energy investments until share prices fell much lower.

In a more recent example, shares in Wal-Mart (WMT) have declined from $90 in early 2015 to less than $59 at the time of writing this article. I believe that the shares were likely overvalued in early 2015, as they were selling for close to 18 times expected earnings, which is a lot for a large slow-growing retailer. Currently, shares do look cheaper. However, as I explained in a previous article, the expectations behind the fundamental growth in earnings seem to have changed. If you believe that the business will not be able to grow earnings per share by more than 3% - 4%/year over the next decade, then the intrinsic value of the business will not grow enough to provide a satisfactory return on investment. If you however believe that the business can grow earnings by 5% - 6%/year or more, and can pay a nice 3% dividend in the process, then Wal-Mart could end up creating a nice amount of wealth and passive income for the share owner.  In my case, I am not happy that Wal-Mart has been unable to grow earnings per share for several years in a row, and that it will be unable to grow earnings per share for the next two - three years. I am also not happy by the low dividend growth over the past two years. As a result, I am going to pass on adding to my stake. The only return I could generate is speculative ( if prices go from $60 to $80). As someone who is not a market timer, but focuses on long-term fundamentals, this is a game I don't play so I won't go there.

Using a screen based on price, such as decline from a 52 week high or a decline year-to-date could be helpful in a first step process to uncover undervalued companies. I say first step, because the investor also needs to take into consideration any changes in underlying earnings power. If the earnings power is impaired, then it is quite possible that the decline in price is not only warranted but could also continue as well.

As the old saying goes, do not try to catch a falling knife. What it means is that a company whose stock is in a steep downtrend could continue being in a steep downtrend for a while. This is where purchasing small amounts regularly could help soften the blow. Another thing that could help is to wait until the price stops falling, before initiating those purchases.

In my investing, I do not look at 52 week lows or largest drops for the year. I have found that having a list of companies that fit a certain pre-determined criteria, and then screening this list using my criteria is most helpful in uncovering good opportunities.

To summarize, a low price, or a decline in the price is not sufficient to determine if a business is bargain. Rather, the important factor to look at is the ability of the business to generate earnings. If this ability is not impaired, and the stock is selling at a low valuation, then it could be a good value to add to.  If the ability of the business to generate earnings is impaired however, the stock might be a pass for dividend growth investors.

Full Disclosure: Long WMT,KO, CVX, XOM

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