I normally choose what to buy from my watchlist based primarily on share price momentum. This is for good reason – momentum is a proven phenomenon. However, this may mean I am neglecting occasional opportunities to ‘buy the dip’ in the less well-performing shares on my watchlist i.e. buying shares when their prices have (hopefully temporarily!) fallen. A number of the shares on my watchlist have recently successfully recovered from temporary dips. Buying the dip could be a useful addition to my arsenal, so I’ve thought through whether and when I might employ it.

Pros and cons

Buying the dip makes good intuitive sense. If you are confident in the business’ long term prospects, then why not buy it when the market  is most pessimistic about it. There is potential for it to be more mispriced at this point. Long term quality investors with a lot of capital to invest, like Buffett, seem to swear by waiting patiently for their favourite businesses to go ‘on sale’. I’m sure they must have a point.

That said, I’m not so convinced about ‘buying the dip’. It goes against the proven statistical factor of momentum, so you will on average not have the odds on your side unless you pick the right stocks. While it capitalises on mean reversion, the tendency for valuations to revert to mean if they get too low (say in a crash) or too high (say in a bubble), I think this is a phenomenon more relevant to the market as a whole rather than individual shares. Most importantly, the main drawback of a buying the dip strategy is that it requires more conviction. You need to be confident that the dip has occurred for spurious reasons, not because the investors are correctly anticipating difficulties on the horizon.

For these reasons, I’ve avoided buying the dip in general. I’m also very wary of diluting ‘my edge’ – I’m starting to get together a strategy that seems to work. I think most would advise that I’d be better off focusing on honing it further and specialising, rather than trying to expand my box of tricks.

With these caveats in mind, I think there are still some circumstances where it could make sense to be looking for opportunities to buy the dip. Primarily, I think it’s useful to have something else up my sleeve for those situations where momentum strategies work less well i.e. when markets are choppy or at points of inflection. If used sparingly, I also think it can be a useful source of diversification, pushing me into some stocks that ‘zig’ when the others are ‘zagging’.

When to buy the dip?

I think the main point is that I only really want to be looking for opportunities to buy the dip when market conditions are choppy or crashing. Otherwise I’m better off focusing on momentum. Even in the right conditions, I want to limit overall exposure to dip buying – only if the opportunity looks a lot better than the higher momentum alternatives available at the time.

I don’t think I need to stray beyond my watchlist of high quality shares to successfully buy dips. However, the conditions I’m looking for are slightly different to my normal high momentum candidates. For buying the dip, I’m more interested in the degree of conviction I have in the business’s prospects rather than momentum. This conviction can comes from a few sources:

• Some support to the share price i.e. not a ‘falling knife’
• Positive news flow or at the least bad news which I am confident is temporary
• A cheap valuation will give more potential upside and a ‘margin of safety’ if things don’t go as hoped

Support

It goes without saying that share price momentum will not be good if you are trying to buy the dip. However, I don’t think it means you should ignore the share price entirely. In my experience you are better off waiting for some signs that the share price has found some support than trying to catch a falling knife. In the short term, a price can fall a lot more than you expect, even if a share is undervalued. It’s better to buy after the bottom has been reached than before, particularly if you’re using stop losses. There is an element of judgment in identifying support but I don’t think it needs to be particularly sophisticated – the price bouncing several times of the same level generally indicates that more sizeable investors have started buying at that level.

News flow

Even more important than the technical support is having confidence that the upcoming news flow will be good. In my experience, more often than not poor share price momentum tends to be a predictor of poor news, as investors will often tend to correctly anticipate bad news. They still often get it wrong, but if you are going to bet against the direction of the market you should be confident that you are right and the market is wrong.

Because of this, you should in general avoid buying the dip whenever the potential for bad news or risks have been flagged in prior news announcements. The market tends not to be very efficient at appropriately discounting these risks and while sometimes they don’t amount to anything, often they do. Overall the reward to risk will tend not to be in your favour.

You should also be aware of when the next news announcement is due. Sometimes it may make sense to buy just before this announcement, if you anticipate that it may be the catalyst for a bounce. Other times you may be better off waiting till after an announcement to buy to reduce the risk of bad news. It depends on the specifics of the situation.

I’ve come across two main situations where the market seems to sell off for no good reason. First, where a share is particularly illiquid and suffers excessively during a more general bout of market weakness, even when the preceding news flow is unequivocally positive with no obvious risks. Second, where the investor concerns that have caused the dip are well documented or related to recent news, but are ill-founded (or have been over-reacted to). It goes without saying that you need to know the business pretty well to be confident you are in the latter situation. It’s also worth bearing in mind that the share price can sometimes take a long time to recover from seemingly bad news, even when it seems likely not to be a big deal in the long run.

Valuation

When buying the dip, I’m likely to pay more attention to the valuation than I might normally do. A cheaper valuation indicates more potential upside. It also will in general mean the share price will not fall as far if news is worse than expected – ‘the margin of safety’. However, I would be careful not to put too much weight on the margin of safety concept. Valuation provides little safety against a further deterioration of trading conditions, so best not to rely on a cheap valuation alone unless you have a lot of conviction in the business’s long term prospects (which will be severely tested if trading deteriorates).

Current opportunities

One of the main reasons for writing this post was more practically to scout out the current opportunities. I’ve had a look through my watchlist at the worse performing shares, to see if I can identify any upcoming opportunities to buy the dip. These are the shares I wouldn’t normally look at following my current process of sorting my watchlist by momentum when deciding what to buy.

The following six look like the most interesting:

Thor

Thor is the largest US supplier of recreational vehicles. It is highly profitable and has benefited from a boom in demand over the past few years.

• Support: Thor has been in a downtrend over the last few months and is down about 33% from its high. It looks like it maybe starting to find support around the $100 level, though it is early to say for sure.
• News flow: the recent news has been relentlessly positive so the severity of the recent price drop might seem quite surprising. I’m pretty sure that the reason for it is anticipation that the current boo in demand is temporary, Thor may be near its cyclical high and that growth will unwind soon. Thor has been bullish on its prospects in its recent statements, claiming that the boom in demand is secular rather than cyclical. The next trading update is due in a few weeks time.
• Valuation: the valuation is extremely cheap. Thor is predicted to continue growing earnings at quite a clip for at least the next couple of years, though is rated on a forward PE multiple of only 10. This seems pretty stingy to me even accounting for the likely cyclicality.

Overall, I like the look of Thor as an investment candidate. I am comfortable that I understand the reason for the drop off in price and that it is likely to be excessive. However, I would be inclined for the price to stabilise rather than buying straight away. One to monitor in the lead up to (and following) its next results.

Superdry

Superdry own the eponymous brand. I’ve owned it a couple of times before but am yet to trade it very successfully.

• Support: Superdry has fallen 26% from its high at the beginning of the year. It has fallen to around the £1500 level where it has spent a lot of time trading over the past few years. I’d say this means it is fairly likely to find support, even though the price is more immediately still in a downtrend.
• News flow: the recent news flow has been reasonably positive. Superdry’s last trading update confirmed it was trading in line with expectations. However, LFL growth may have slowed more than some were hoping for, given its recent heavy capital investments. Its next trading update is imminent.
• Valuation: the valuation looks extremely cheap, all things considered. It trades on a forward PE multiple of only around 14, despite being expected to grow at a reasonable rate for the next few years.

Overall, Superdry looks very interesting. Fundamentally it just looks far too cheap for a high quality brand. However, I don’t see any reason to buy ahead of its next trading update. I think better to wait and see, but be ready to pull the trigger straight away if the results are good.

Paddy Power Betfair

Paddy Power Betfair is the largest UK gambling business formed following a recent merger. I’ve been interested in it for a while, though its performance since the merger has not followed the same stellar trajectory as the two predecessor companies.

• Support: PPB has fallen by 33% from its high. It has been falling for over two years now – falling for such an extended period is generally not a good sign. There are not very strong signs that the share price has found support. However, it is around the same level from which it bounced temporarily last September.
• News flow: has not been that great, but not that bad either. PPB has faced some regulatory pressures and slower trading over the past year or two, but this seems likely to be temporary. I am reasonably confident in long term prospects.
• Valuation: the valuation seems pretty cheap, given the underlying business quality, though is not outstandingly cheap.

Overall, it looks worth monitoring though I wouldn’t be rushing out to buy any just yet. It’s probably better to wait and see if it gets any cheaper or better trading resumes.

Auto Trader

Auto Trader operates an online platform for buying and selling cars.

• Support: Auto Trader’s price is 16% off its highs. The price has been stagnating rather than falling for the last two years. The price is above what is apparently quite strong support, having bounced off around £3.20 a number of times.
• News flow: despite a fairly stagnant underlying car market, Auto Trader has been performing reasonably well, though growth has slowed down considerably over the last couple of years. Auto Trader has been investing in share buybacks as its share price has languished. Its next trading update should be in just over a month.
• Valuation: the valuation is not at bargain levels though seems pretty cheap for a such a profitable high quality business with quite a bit of growth still in the tank.

Auto Trader looks like a pretty good candidate investment to me, though would need to be a bit cheaper to be really outstanding.

CBOE Global Markets

CBOE is owner of the VIX volatility index as well as operating stock and derivatives exchanges. I owned it fairly recently, though sold out after a recent disappointing trading update.

• Support: the price down about 30% from its highs. It is in a clear downtrend, with no immediate signs of finding support.
• News flow: CBOE just issued its last update about a week ago and it was actually ahead of expectations – not to shabby. However, this comes on the heels of a rather poor preceding update and the news that several inverse volatility index trackers were forced to liquidate following the spike in volatility in February this year. I don’t think the news flow is likely to be too bad going forward from here.
• Valuation: the valuation is not super cheap but seems pretty reasonable for such a high quality business.

I really like the business and am likely to buy again in the future, but at the moment neither is the price sufficiently cheap, nor is there sufficient momentum for me to consider buying in the near term.