Are you waiting to buy on dips? Is it a good investment strategy?
The idea of buy on dips is not a bad one. But when used to buy momentum stocks on small corrections leads to a disaster.
Warren Buffett, The Oracle of Omaha has said, “Be greedy when others are fearful and be fearful when others are greedy.”
Depressed markets offer investment opportunity to buy quality businesses at cheap valuation. He refers such opportunity as fat pitch. But, buying in times when everyone else is selling and fear factor is high, it is not easy at all. Most investors fail to exploit such opportunity. In fact, most investors end up following a 'Buy on dips' strategy and think that they follow the footsteps of Warren Buffett. The idea of buy on dips is not a bad one. But when used to buy momentum stocks on small corrections leads to a disaster. Applying value rationale to momentum stocks doesn't work. I call this value in momentum strategy. Let us understand how this trap works.
Few days back a friend of mine called me and said he wanted to invest a sizable sum of money in equities. Knowing that he has never invested in equity considering it risky, I asked him a simple question, "Will you hold onto your equity investments if markets fall by twenty percent in next six months?" He changed his mind quickly, and said he would not invest in equity now but when Nifty drops to a level of 9,000. Now, this is interesting. Markets can go up, down or remain sideways in next six months. But he has now decided to follow 'buy on dips' strategy or one may say I made him think about buying on dips. Is this a right strategy? That’s the question.
Global market including India, are in upward momentum and are making new highs. Valuations are not cheap as price-earnings ratio at the top end compared to historic levels, liquidity flows and momentum drive the markets higher. Veteran Investor, George Soros coined the term ‘reflexivity’ to explain extreme price movements way beyond fundamentals. He said, “Rising prices attract buyers, whereas falling prices attract sellers.” This is very different than what our economics professors tell us, but that is the fact. It drives momentum in asset prices and creates bubble on the way up and fat pitch like value investing opportunity on the way down.
The biggest problem with the investors is that they are ‘human beings’ and they have emotions. Both momentum and value are successful investment strategies. But, searching for 'value in momentum' invites trouble. Let us understand how it unfolds.
Most investors come to know about the stocks that have performed really well in the recent times from various sources. Business channels, pink newspapers or friends sharing their success stories etc. Once they know about a stock like this, they go back and check whether they can invest into it and make similar fortunes. But, the price of the stock has already soared up in the recent past and it prevents him from buying stock at prevailing price. Do they drop the idea of buying that stock? The answer is no. They keep tracking it and wait for ‘buy on dips’ opportunity. They decide to buy it, if it comes down from the current levels or recent highs by say twenty percent. They jump out of their chair and grab it as soon as it falls. Don’t get me wrong, there is no harm in buying a stock at a price twenty percent lower than prevailing price. But for that, we should have done some analysis- fundamental or technical-to suggest that it is a great price to buy. In most cases, investors look at 20% fall from the price anchor in their mind and nothing else.
So our ‘buy on dips’ investors buy a stock just because it has fallen 20% and ignore everything else. He does not ask important question to himself before buying. Why the stock is falling? What is the fair value of the stock? They enter the stock at a price level where momentum investors are exiting. They enter at a price level, too high for Warren Buffett style value investors to even consider buying it. These buy on dips investors become the door of exit for the momentum investors who have decided to dump the stocks. For example in my friend's case, his Nifty anchor level is set at around 9900-10000., He is looking at an entry at ten percent lower from that level. His 'buy on dips' level. If you look at some metric like price-earnings, you will realize that there is nothing much to choose between Nifty level of 9900 and 9000. At 9900 Nifty, the trailing twelve months price-earnings ratio is around 25 and at 9000 it would be around 23. By no means 23 price-earnings ratio, fits into fat pitch definition of Warren Buffett style value investors. Nifty may continue to decline from even 9000 levels till it becomes attractive to value investors. If he decides to add to his position at every decline, or say buy on every small dips, his problem gets compounded. We have seen plenty of examples in the history of such ‘buy on every dips’ traps. Tech stocks in year 2000, real estate & infrastructure stocks in 2008 and so on. Investors are still nursing their wounds and blame market manipulations for their losses. The fact remains that the biggest culprit for their losses is a thoughtless strategy of ‘buy on every dips’ and nothing else. My sincere advice is that please stay away from the only price driven "buy on dips" or even worse "buy on every dips" strategy. Value and Momentum investing are two very different things and neither Warren Buffett nor Ben Graham has advised us to go and search for ‘value in momentum stocks’.The writer is Professor & Chairperson (Finance) at School of Business Management, NMIMS, Mumbai.