Choosing which stocks to buy is never an easy task especially when you have your own hard-earned after tax pounds, sterling and pence on the line – it is must easier to fritter away other people’s money.
Today’s post takes a look at one of my own investments for The Thomas Value Report and specifically how I use a specific price alert (a large decline in a stock’s price) to trigger fundamental research to help me choose whether to buy stock or pass.
We will look at two stocks that suffered huge price declines: one I bought into recently and one I discarded based on the type of fundamental research I like to do.
Ah yes Hornby (LSE: HRN).
Our family had several of their train sets when I was growing up and I clearly remember each set never having all the pieces.
Come to think of it I think I have a set in a suitcase in the garage – when I have the time and inclination I’ll check to see if it’s worth keeping or selling on ebay – hopefully they are complete sets.
What’s not worth keeping are Hornby’s (LSE: HRN) shares which have languished down at multi year lows for a long time:
Hornby (LSE: HRN) Price Chart
Just for ease of reference here’s IG Group’s (LSE: IGG) price chart:
IG Group (LSE: IGG) Price Chart
Now the point I’m making today and one which I made in yesterday’s post is that just because a stock suffers a massive price decline does not mean it should automatically be purchased. Choosing which stocks to buy is a little more complicated than that.
The last time I took a look at Hornby (LSE: HRN) in a post called ‘Why Investing In Turnarounds Is Fraught With Difficulty‘ last year I noted that Hornby’s share price had plummeted 72%:
On 20 August 2015 Hornby (LSE: HRN) closed at 109p. Recently (April 2016) Hornby’s share price hit 30p representing a 72% decrease.
Why I Didn’t Choose To Buy Hornby’s Stock
I also noted some of the difficulties Hornby had been coming to terms with including:
- It’s bank changeing the rules so that it does not break it’s banking covenants
- A February 2016 RNS in which it expected a substantially wider trading loss than previously forecast
- A massive and wide ranging turnaround plan which included modernising it’s product sourcing, improving management of the supply chain, upgrading logistics, upgrading warehousing, upgrading it’s stock control processes and speeding up deliveries to customers.
- The updating of it’s IT systems
Turning to the numbers Hornby’s return on capital employed over the last four years has not even registered in double digits except for the latest year in which it returned minus 13.80% according to Morningstar.
Also since 2012 revenue, profits and earnings have all taken a nose dive and dividends have long since gone.
Added to the mayhem was a recent shareholder revolt to oust the current chairman due to an ineffective turnaround strategy.
I could go on but the picture is clear that Hornby (LSE: HRN) or more importantly it’s board do not look as though they can resolve the mini crisis they find themselves in any time soon.
Why I Did Choose To Buy IG Group’s Stock
As mentioned in yesterday’s post IG Group’s numbers are superior:
- double digit returns on capital employed over the last five years (as high as 55% as low as 36%)
- consistently strong balance sheet with a current ratio of 4.85
- rising dividends, earnings and profits
- despite regulatory headwinds expects profits and earnings to be ahead of the previous year
- Market leader in the business for over 40 years
- Dividend yield of 5.4%
Also the management team is highly competent as evidenced by the high rates of return on capital employed all of which helps me to sleep at night.
In the jungle the mighty jungle…
Every stock that is ever purchased regardless of whether the business behind it is sound or not has the chance for its price to go lower and it has taken me a very long time to come to terms with this aspect of the value approach.
It’s the same with IG Group – if their price declines to below that which I originally purchased stock and if the fundamentals remain largely unchanged then there would be no reason not to buy more.
Buy stocks when the outlook is not good
Overcoming Fear and Greed: Psychological Framework and Value Mindset
One of the ways I overcame this irrational fear of losing money was to forward test Benjamin Graham’s value approach and you can access the results in ‘Testing Benjamin Graham; Final Results‘.
The way I managed to ‘hold my frame’ when stocks decline in price after I’d purchased them is to maintain a long-term approach and not to worry about the day-to-day antics of stock prices.
This helps me to choose the right type of stocks to buy by making sure that their long-term financial record was sound and that any problems they may be experiencing now is likely to be temporary.
During the forward test I noticed how the price behaviour of stocks over long periods of time became less relevant and thinking more about how the portfolio is made up of a diversified group of stocks purchased below their intrinsic value is much more important.
I’m comforted by the fact that the stocks I choose to buy literally pay dividends (for the most part) so I end up being paid to simply hold stocks in The Thomas Value Report as I wait for the market to catch up with economic reality.
I hope today’s post was a useful behind the scenes look at how I choose stocks on an individual basis and if you like these types of tutorial posts click here to access more that I’ve written over the years.
As for Hornby they are due to publish their prelims on 21 June – maybe they’ll announce some positive news that will change their fundamentals/intrinsic valuation – I’ll be taking note just to be sure.