When To Buy?
The key questions addressed in this chapter include:
- Is there any merit in trying to time the market for buying and selling stocks?
- What does a relative valuation multiple tell you about the intrinsic value of a business? And,
- To what extent, and in what cases, can you rely on PE multiples to drive your buying and selling of stocks?
In this book so far, the author has discussed the question of what stocks to buy. The Marcellus framework of identifying companies with clean accounts, a track record of prudent capital allocation and presence of strong and sustainable competitive advantages are helpful guides to answer this question. Once you know what you need to buy, one common question investors have is—when to buy? As soon as investors come to this juncture, they tend to get mentally submerged in a sea of questions, like:
‘There are elections in the US this year. Should I wait until we know who the next US President is going to be, before buying this pharma company that gets 80% of its revenues from the US?’
‘This bank reported good results for this quarter and the stock price has gone up by 10%. Should I wait for it to correct before buying?’
‘This consumer goods stock is trading at a PE multiple of 30x, while its competitor is trading at a multiple of 20x. Should I sell the ‘expensive’ stock and buy the ‘cheaper’ one?’
Such questions broadly cover two aspects of when to buy or sell a stock. The time and the price. In this chapter the author tries to answer these questions.
Timing the market
Between January and March of 2020, as the COVID-19 pandemic began spreading across India and local authorities in some cities started limiting economic activity, the Sensex index fell from its then lifetime high of 41,953 on 14 January 2020 to 25,891 on 23 March 2020—a decline of 38% in just a little over two months. Then came the announcement of a 21-day nationwide lockdown starting on 24 March 2020. A few investors in Marcellus's PMS portfolios expressed worry about the economic impact of the lockdown on nearly all economic activities across the country and a desire to redeem their investments and shift out of equity to perceived safer investment avenues. At that point in time, amid an unprecedented crisis, it would have been natural to expect the markets to decline further, causing more significant wealth erosion, right? No.
23 March 2020 turned out to be the bottom of the Index. It took forty-nine trading sessions for the 38% fall from peak to bottom, and in the following forty-nine sessions, the Sensex had already recovered by 32%. And by the end of 2020, Sensex had scaled a new all-time high.
The above example indicates how the market typically behaves, not just during periods of crisis but also in normal times. Unfortunately, the example also shows how most investors react to market behaviour and, in panic, tend to sell at the worst possible time. The futility of trying to time the market has been proven repeatedly in scores of studies.
It is practically impossible to identify the lowest stock point for executing your buys and identifying the highest significance to selling them. It would be nothing but incredible luck for anyone to achieve this consistently.
Why is timing not relevant for consistent compounders?
Stock prices should ideally reflect the present value of the business's underlying cash flows, and in the long term, they tend to do so. However, in the short term, stock prices fluctuate depending on market participants' assessment of multiple factors, most of them external to the company. For example, stock prices of export-oriented companies might react to every small change in the exchange rate up or down, even though over the long term, it might depreciate steadily. As a result, provided the underlying asset (company or an index) delivers a modest or healthy growth in earnings and cash flows, it does not matter how the near-term stock price moves. And in turn, this means that for such stocks, it does not matter whether the entry point of one investor was 20% higher or lower than another's.
In the case of companies in cyclical businesses, earnings tend to be volatile over a period, with a few years of strong growth followed by a few years of weak or even negative growth. As a result, it matters when they are bought or sold for such stocks. However, the challenge with these stocks is in knowing what the right time to buy or sell them would be.
Since the volatility in earnings is driven more by external factors, including macroeconomic variables, and less by the fundamental strength or weakness of a company, it becomes much more difficult to time the right cycle. For example, the earnings of a metals company depend not just on the producer's efficiency but also on the price of metals in international markets, which is determined by multiple global demand-supply factors.
Do P/E valuations matter?
The other aspect of when to buy (or sell) a stock is centered on its pricing or valuation. For example, should you buy a stock if its price and earnings multiple is 'low' or 'cheap' compared with peers or the broader market? And should you sell a stock with an earnings multiple higher than its peers or its sector average?
As noted earlier, the intrinsic value of a stock reflects the present value of the company's cash flows. However, to assess the stock's value, investors more intuitively use relative measures, such as price-to-earnings (PE) multiple or price-to-book value (P/BV) multiple. As a rule of thumb, a company trading at a relatively lower PE than its peers is considered to be more attractively valued.
The comparison, however, ignores a number of factors that drive the value of a business—the return on capital and the reinvestment rate being the chief amongst them. It is like saying a plot of land should be valued at a certain price per acre because someone acquired the neighbouring plot of the same size at the same price. What if the neighbouring plot had fruiting trees or an oil well while the other did not?
However, it isn't easy to forecast the cash flow for each year, especially for periods in the distant future. As a result, most practitioners forecast cash flows for the foreseeable future of the next five, seven or ten years and then assign a terminal value to the remaining cash flows. The terminal value is the present value of all cash flows beyond the first five, seven or ten years, as the case may be. While calculating the terminal value, the cash flows of a business are assumed to keep growing at a constant rate for perpetuity.
Remaining invested for the long-term is the key to steady and healthy stock price returns. It is practically impossible, and not worth the time and effort it takes, to time short-term buys and sells and hope of making consistent returns.
The value of a stock is driven by two key elements of its underlying cash flows—growth in these cash flows and, more importantly, the longevity of the cash flows.
Most valuation methodologies, including absolute methods like the discounted cash flow and relative methods like P/E, EV/EBITDA, etc., ignore or undervalue the longevity of cash flows. This makes investors overlook stocks that appear 'expensively valued' but could be priced much below their intrinsic value. Investing in Consistent Compounders addresses the two key aspects of an investor's dilemma about when to invest—the timing and the pricing.