An interesting formula that helps to buy stocks when they are down

There is a variety of ways to make money from shares. But, over time, it has become clear that all successful investing is based on accepting one essential feature of the markets: it is impossible to know what will happen to the price of a stock in future. From this understanding flow multiple trading and investing strategies. One of them is buy-low, sell-high. While this is one of the most popular and oft-repeated investment maxims, how does one define what is ‘low’?

Luke Wiley suggests a simple formula. Look for stocks that have hit 52-week lows and judge them on four basic questions:

1. Do they have durable competitive advantage?

Is it the kind of company that is hard to compete with, either because it has cornered a difficult market or because competing with it would require an unreasonably high investment by others?

2. What is the purchase value of the company relative to its free cash flow?

If someone were to come in and buy the entire company, would the free cash flow being generated be well in excess of simply investing in a 10-year Treasury bond? After all, the cash flow on a 10-year Treasury bond is said to be ‘risk-free’ while the free cash flow from a company is not without risk.

3. What is the return on invested capital of the company?

Is the company using its money wisely to create returns below its cost of capital? It is using its money well to create returns, or is it taking on bad investments that don’t pay off.

4. Can it pay off its long-term debt quickly?

There are several companies that are making a lot of money, but should revenues stall or decelerate, could their long-term debt be paid off within a short period with free cash flow?

Wiley claims to have spent years refining the principles behind this—back-testing data and putting his own money on it; the results have been impressive. He asserts that his clients—those willing to take a slightly different approach to investing their requirement dollars—have never been happier.

The 52-week low formula is based on the idea that even the best companies go through problems when their stock value heads down. This leads you to investing in a good business trading at an attractive valuation. You are buying into a company that is out of favour with the investing public and Wall Street analysts.

Of course, you don’t just buy any company, trading close to its 52-week low. You have to always keep an eye on the first part of the investment approach: good quality business (that is temporarily out of favour with the market). The idea is to bet on something afflicted with a mild infection rather than a terminal disease.

Buying 52-week low strategy is a clever way to take two important steps while buying stocks: narrow down a wide universe of stocks and remove behavioural bias. “It narrows down the wide world of possibility when it comes to investing by starting with an end goal—outperforming the market, with less downside risk-and working backwards. It is a logic-based, disciplined approach to narrowing down the 3,000 publicly traded companies in the market to the 25 that represent the best opportunities for creating real value in the coming months,” writes Wiley.

More importantly, the 52-week low formula ensures that our behavioural basis is dealt with effectively. Far from buying stocks at their lows, we are attracted to stocks that are shooting up. Too much money is lost because investors herd behind what is popular, follow emotions, instead of the data. This can be eliminated only by a disciplined system of staying away from the ‘highs’ and looking for the ‘lows’ through an objective formula. Zeroing in on 52-week lows is a big help in that process.

I believe this facet of the approach (helping to deal with behavioural biases) makes it one of the best I have come across. There are lots of good approaches to buying stocks. Many cannot follow them because human beings, by nature, are not very rational. Successful investors train themselves to deal with their own biases. The 52-week low approach helps you remove your biases more easily. Definitely worth applying.