Fire sale: always be aware of the dangers of ‘buying the dips’

Fire sale: always be aware of the dangers of'buying the dips'
Photo: FirmBee, Pixabay

In automotive parlance, there’s this term that is referred to as barn finds. The term itself refer to instances in which someone encountered a car, usually a classic, abandoned in a garage or a barn somewhere and more often than not, is in such a poor condition that a complete restoration might be in order. The value of the car itself is normally considerably higher than the cost of restoration, which is why you should still consider yourself incredibly lucky if you’ve ever find yourself in one such situation.

If you think about, a barn find could be considered an incredible investment opportunity. The price of classic cars has historically moved upwards and there are instances in which unrestored cars have managed to fetch a price in the millions of dollars. There is no exact equivalent of barn finds in the world of stock market but as would be explained in trading courses or other investment resources, the concept of buying the dips has some similarities.

Buying the dips, explained

The concept of trading, since the days of spice trades and silk road up until the era of Bitcoin and cryptocurrency still hasn’t changed. You buy goods at a certain price and then sell them at a place where those same goods would fetch a higher price. In stock trading, that kind of mentality doesn’t apply since stocks are priced the same anywhere, which is why the question changes from where, to when. As in, you hold off on selling them until those same stocks would fetch a higher price.

The strategy is simple, by monitoring the market and seeing where they’re moving, such as electric cars for example or the development of A.I., you can predict which company is going to hit it big in the near future. Not all of your predictions is going to land but with some proper research and analysis, you should be able to have more hits than misses. The usual strategy is to wait until the prices go up but since the market is both volatile and operates in cycles, there is one avenue that could be explored.

Instead of buying stocks at a normal price expecting them to rise, you buy them when they’re down and sell them once they’ve normalised. This is what the phrase ‘buy the dips’ originates from, as you’re buying them when the price dips below a certain point. At a glance, it doesn’t sound like a bad strategy, undervalued stocks are at least as common as overvalued stocks, but going against the market like this does carry with it certain risks that traders should be aware of.

They’ll bounce back, but the question you should ask is when

You should already know that when it comes to stocks, the market as a collective dictates the price of the stock. If demands are high, the price soars but if there’s a massive sell-off, the price is going to plummet. When you decide to buy the dips, you are essentially betting on the possibility that the market is wrong and that they’re going to realize it at some point. The problem with this idea is there usually is a good reason why the price dipped in the first place.

A disappointing quarterly report for example might simply be an abnormality but it might indicate that business has simply slowed down. It could be because the market is saturated, in which case the company will have to find another avenue for growth or it might simply be the economy is heading into a recession. If it’s the former, a detailed analysis on the company itself is required to see if future growth is a possibility while if it’s the latter, it’s trickier.

During the dotcom bubble burst of the late 90s and early 2000s. Out of the companies that did survive the ensuing chaos, none has been able to recapture those previous highs. It took more than a decade for companies like Qualcomm, Intel and Cisco to at least get back to similar levels they enjoyed back then and it still isn’t as it was then. And as for the companies that didn’t survive the onslaught, that’s another matter entirely.

There is no guarantee that they’ll ever bounce back

Yes, you could make the argument that companies that didn’t survive the market crash during the dotcom bubble era were all companies that didn’t have an actually sustainable business model. Pets.com and Webvan focused too much on growth instead of sustainability and they paid a hefty price for it. The thing is, we’re also seeing the same pattern in today’s climate. Despite major global expansion, Uber is still bleeding cash by the minute and Tesla’s factory is still not operating in full capacity even though their entry-level model, the Model 3 sedan has been technically on the market for a full year but I digress.

Heading back to the the issue of buying the dips, let’s now focus our attention on companies during the real estate crash of the mid 2000s in the United States. The argument outlined so far is that as long as you focus your investment on notable companies with sustainable business model, you should be okay but let me introduce you to Bear Sterns and Lehman Brothers, two of the highest-profile victim of that financial crisis.

Unlike the likes of Pets.com, these are two historical companies that have been around for quite a while, more than 150 years in fact in the case of Lehman Brothers. The sentiment back then was that when shares for these two companies fell below a certain point, those who practiced the buying the dips philosophy would no doubt be tempted to get a piece of the action. These two companies had a sustainable business model so it’s not completely baseless.

And yet, we all know what happened in the end. They had too much exposure and it’s been known since that they’ve been more or less cooking the books to make sure that their business foundation looks more solid than they actually are. Goldman Sachs, JPMorgan Chase and Morgan Stanley were eventually saved by the government but Bear Sterns and Lehman Brothers didn’t. No matter how notable the companies are, buying the dips strategy is always dangerous.