The Purchase Decision

Benjamin Graham and the Power of Growth Stocks, Part 5 in a series

 

Price is what you pay; value is what you get.
                                    — Warren Buffett

The volatility of the stock market gives investors a continuous opportunity to trade their stocks at a favorable price if they are able to make their decisions based on value rather than emotion, according to author Frederick Martin of Disciplined Growth Investors.

In his book, “Benjamin Graham and the Power of Growth Stocks” (McGraw-Hill), Martin says that investors should answer two questions before they decide the price they are willing to pay for a stock:

1.      What is the true value of the stock?

2.      What is your “hurdle rate”?

There are a variety of ways to determine the value of a stock. We explained one method espoused by the late Benjamin Graham in an earlier column. But regardless of the method you use to value the stock, you need to hold true to that value, and let the movement of the market dictate the time or opportunity for you to buy that stock.

The second question involves the “hurdle rate,” which is the average annual compounded rate of return you hope to earn from your investment portfolio. That rate can vary significantly from one investor to another. A conservative investor may choose a hurdle rate of 5 percent, while a more aggressive investor may shoot for 8 to 10 percent or more. How should you settle on a hurdle rate? Martin suggests that your hurdle rate should be determined based on your investment requirements and your ability to achieve those objectives.

Once you’ve determined the ideal return you would need to achieve your objectives, Martin suggests you add about 2 percent for your hurdle rate to compensate for cyclical market downturns. So if you hope to achieve an 8 percent average annual return, you would set your hurdle rate at 10 percent. And once you’ve set it, don’t change it.

“It’s important that you stick with (your hurdle rate) even though changing market and economic conditions will often tempt you to make a change,” writes Martin. “Unless your long-term goals have changed, you need to ignore the market conditions and maintain a nearly cult-like devotion to your hurdle rate.”

In his book, Martin suggests that investors determine what the value of a company stock will be several years into the future. That way, when you are determining the price you’re willing to pay for a stock to meet your hurdle rate, you can figure in the price you need to buy the stock for today in order to achieve your hurdle rate in the years ahead.

For instance, if you have a hurdle rate of 10 percent, and you determine that a stock will have a value of about $50 seven years from now, you should buy that stock only if you can buy it at a price that represents at least a 10 percent return over the next seven years. At a 10 percent annual compounded rate of return, the price would essentially double over the next seven years. That means you would need to buy the stock at $25 or less today to achieve a 10 percent return over the next seven years (assuming the stock performs true to your projections and reaches $50 a share).

“By establishing a set hurdle rate, you are able to make the purchase process a very simple, straightforward decision,” explains Martin. “If you can buy the stock at a price that will give you a return that is equal to or better than your hurdle rate, you can feel free to buy the stock. If you can’t buy the stock at a price that will give you your hurdle rate or better, you don’t buy the stock. It’s a cut-and-dried decision.”

STAYING TRUE TO YOUR PURCHASE PRICE

Martin says there are three situations for any stock at any given moment—seller’s advantage (a price that favors the seller but is too high for the buyer’s hurdle rate), fair price (both buyer and seller can be satisfied that a fair price is being paid), and buyer’s advantage (the stock is selling at a price that should yield a return above the buyer’s hurdle rate).

Why would any investor be willing to buy a stock at a disadvantages price? Martin says there are two primary reasons. “Either he doesn’t know what the company is worth or he hasn’t set a hurdle rate—or he violates that hurdle rate.”

By only buying stocks at a price that meets your long-term hurdle rate you can significantly improve your chances of achieving outstanding long term returns. But unfortunately, cautions Martin, staying true to your purchase price does not eliminate the chance that you may lose money or fall below your hurdle rate on a specific stock.

“Occasionally a well-developed forecast of the future value of a stock is too high because of events that occur after purchase of the stock,” writes Martin. “This is the best argument for diversification, so that one stock does not fatally damage the portfolio returns.”

There are no guarantees in the stock market, but setting a hurdle rate and staying true to your purchase price can dramatically improve your chances of a positive return on every stock you buy.