3 Reasons to Cheer a Market Drop

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Over the past two years I’ve started investing in individual stocks. I’ll talk about why I made that decision in another post. But the change for me has had some interesting consequences.

The most significant consequence is that I watch stock prices much more closely. And like many investors, it’s great to watch the market go higher. How many of you love to sign-in to your brokerage account at the end of the day to see how much you’ve made in the market?

But here’s the reality for us long-term investors–we are much better offer if the market languishes. Here are three reasons why:

1. If you are buying stocks, including mutual funds, the cheaper the better. Even if you invest only in a 401(k) or IRA each month, the lower the price, the more shares your money will buy. A higher balance in your retirement account may make you feel better, but a rising market just makes your next purchase more expensive.

Now, the above point is easy to see whether you buy individual stocks, ETFs, or mutual funds. The next two, however, really came into focus for me when I started investing in stocks (although they hold true for mutual fund and ETF investors, too).

2. If you are reinvesting dividends, the cheaper the better. Reinvesting dividends is really no different than buying more of the same investment. It happens automatically, so you may not notice, but you are still buying. I’ve invested in a number of dividend paying stocks (e.g., Pepsi, Verizon, and Apple (which will begin paying dividends)). Each quarter when the dividend is paid, the proceeds are automatically used to buy more of the stock. The cheaper the price, the more my reinvested dividends can buy.

3. If a company is buying back its own stock, the cheaper the better. When a company buys its own stock, the cheaper the stock the more shares its money will buy. With more shares out of the market, my ownership stake goes up. This is why so many stock repurchase programs by management are terrible for investors. Management has a tendency to overvalue shares of its own company. When a company pays more for its own shares than the intrinsic value of the stock, investors are harmed. It’s really no different than if management overpaid for any asset.

On this third point, Warren Buffett’s recent letter to Berkshire Hathaway investors is a must read. Beginning on page 7, he uses Berkshire’s investment in IBM to explain the relationship between low stock prices and a company’s decision to buy back its own stock. It’s a must read!

As another example, I invested about $10,000 in Apple stock one year ago this month. Over the past two weeks the stock has been down more than 10%. I was thrilled.

Apple recently announced that it would start paying a dividend and buying back some of its outstanding stock. With a lower stock price, both moves would be better for investors.

As you may have noticed, however, earlier this week Apple announced that its profits had doubled. As a result, yesterday its stock price was up 9%. While the roughly 70% gain in price over the past year is great, it’s not great for the upcoming dividends and stock buyback program. I’m happy the company is doing well, I just wish its price wouldn’t do so well.

Published or Updated: April 26, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Thanks for writing such an informative post, Rob!

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