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If you’re a long-term investor, someone smart has probably told you to “buy the dip.” And in many cases, they’re right.
Historically, the stock market has trended upward and has reached new highs after every broad-based decline in prices. That has meant that if you were invested in the broad stock market, even the worst bear markets — dips of 20% or more from recent highs — represented a chance to buy an appreciating asset on virtual sale.
“If you have a solid, long-term investment, it’s always attractive to buy the dip because you always get a new high,” says Jeff Buchbinder, chief equity strategist with LPL Financial. “In the history of the S&P 500, every dip has been attractive because you eventually made new highs.”
But what if you’re already invested in or merely interested in owning one stock in particular that has declined in value? Take SpaceX, whose shares are down nearly 40% from the company’s post-IPO closing high in June, as of mid-afternoon Tuesday. That’s even as shares trended upward on Monday and Tuesday amid investor anticipation of the firm’s first-ever earnings report this week.
Pops like these after a marked decline raise a couple of important questions for investors: Is a slide in an individual stock a signal to jump in and take advantage of a rebound, or a chance to cut bait? And how do you tell the difference?
Here’s what investing experts say on the matter.
How to approach buying dips
If you’re interested in buying a stock after a decline in the price, your first move is to examine your reasoning behind the trade, says Richard Reyle, chief investment officer at wealth management firm Questar Capital Partners. Buying simply because you think the price might rebound over the short term amounts to little more than speculation, he says.
“Supposedly, today’s stock price represents all known information,” he says. “Anytime you’re buying for a short-term movement, you’re speculating that I know more than Mr. Market.”
If you’re hoping to buy and hold a stock — or add to an existing position — because of its potential to deliver long-term wealth, buying at a depressed price can be a savvy move, albeit one that requires some research, says David Russell, global head of market strategy at online brokerage firm TradeStation.
“Buying the dip is a sound investment strategy when the price has fallen despite good fundamentals, and not because of bad fundamentals,” he says. “If it falls because of bad fundamentals, then there’s a risk of it continuing lower.”
In investing, fundamentals are the underlying aspects of a business that drive growth or decline in a stock’s price. A fundamental investor considers measures such as a company’s earnings, cash flows and indebtedness when projecting the direction of its stock.
When the outlook for a company’s fundamentals worsens, investors often respond by trading the stock down. But not every pullback has to do with company-specific problems, says Reyle. Sometimes investors sour on an entire industry, or a panic sends the entire stock market tumbling.
“That’s the thing you need to isolate: Is this specific to the company, the industry, or is it just, when the market sells, everything goes down ultimately?” he says.
Absent the stock you like getting swept up in a broader pullback, you’ll have to interrogate why the market has soured on the company and whether there’s been a major change to your long-term thesis for holding the stock, Reyle says.
Fundamentals to focus on
If the market tells you something is going wrong, it’s worth paying attention, he says — there could be a major disruption from a competitor or a sea change in the industry you weren’t aware of. If you’re still bullish, he says, ‘that’s where you better get out your pencils and do your homework as far as what’s going on.”
Of course, even the most astute students of the stock market can’t predict with certainty where stocks will go, and you’d be wise to consult with a financial professional before making any wholesale changes to your portfolio. But if you’re hoping to get an idea of which measures might be worth paying attention to when a stock’s price goes down, here are three places to start.
Margins
When trying to determine a company’s direction, “margins will tell you a lot,” says Russell.
Generally expressed as a percentage, a firm’s profit margin shows how much revenue it retains as profits after costs. A company with a 10% profit margin is netting 10 cents on each dollar it brings in.
Even if a company’s share price is trending downward, expanding margins is a good sign of financial health, says Russell. “Margins are a good gauge of a company’s cost structure and pricing,” he says. “If a company’s pricing is going in a good direction, that usually tells you that the actual fundamentals of the business are strong.”
Free cash flow
A company’s free cash flow is the cash profits it generates after making the capital expenditures to maintain the business. That’s money that can theoretically be used to make acquisitions, distribute wealth to shareholders in the form of buybacks and dividends or generally reinvest in the business. In other words, says Reyle, it gives you the ability to “do a lot of good things for shareholders.”
Beaten-down companies with ample and growing free cash flow may be worth a look. Conversely, companies with little free cash to burn may have less flexibility to get through difficult financial stretches, he says.
“If you’re running a deficit, at some point that catches up to you,” Reyle says. “You’re either financing it with additional debt or additional equity issuance, neither of which are good for the ultimate long-term health of the company’s balance sheet.”
Insider buying
When a stock is selling off, pay attention to who is buying — namely, whether company executives are picking up shares, says Reyle. Executives in corporate C-suites know their companies more intimately than anyone, he says, and they have real skin in the game when it comes to the stock.
“If they know it’s a sinking ship, they’re not going to go put their own resources into it. Their world’s already kind of destroyed already because they’re usually comped a lot in stock,” he says. “So with a dropping stock, if they’re putting the real money into it — six figures and above-level buying — that to me is a buy signal.”
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