After I told my father what I am about to tell you, he called me a charlatan. He said, “You basically tell people that it is okay to lose money on their stocks.” It’s a bit more nuanced than that, but, yes, here is my message to you: When you buy the right company — one that generates enormous cash flow and is run by good capital allocators — a decline in the stock price could be a blessing, not a curse.

Okay, now it’s your turn to call me a charlatan. But before you do, let me share with you two examples: one that has already played out and one that is still very actionable.

In May 2012 I made the case for Redwood City, California, gamemaker Electronic Arts. My firm’s original premise in buying EA was that it looked expensive statistically, but statistics did not capture the company’s true earnings power. EA is transitioning from selling packaged games to digital ones. Digital games come with much higher profit margins; thus, even with little revenue growth, EA’s margins should go up. And they have. In fact EA’s fundamental story worked as we expected. (Here is PDF of my EA presentation)

During the third quarter of 2013, we sold Electronic Arts in two tranches, the first time in the mid-20s, the second time in the high 20s.

However, right after we bought the stock, it declined nonstop for more than six months. Here is where the lesson comes in: A stock decline is not necessarily a bad thing, even if it happens right after you buy (assuming fundamentals have not collapsed). When we buy stocks, we believe they are irrationally priced — that is, selling at a discount to their fair value. But just because we bought a stock doesn’t mean it will not become even more irrationally priced. At the time we buy a stock we believe it is undervalued — otherwise we would not have bought it — but we have no idea whether it will go lower.

There was a lot of good that came out of EA’s stock decline. First off, we had an opportunity to buy more. Second, EA bought a lot of its own stock. This share repurchase created value for shareholders and allowed us to reset our second sell target to the high 20s. (We were initially willing to part with all shares in the mid-20s.)

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Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process (see PDF presentation here), as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

Via: contrarianedge