When is the Best Time to Buy High Quality Stocks?

How to Buy Great Companies at Great Prices

So when is the best time to buy high quality stocks - when a company is firing on all cylinders and everyone recognizes its dominance? Or when it's facing significant challenges, struggling to grow its earnings, and more than a few investors begin wondering whether the company's best days are behind it?

It's easy to be contrarian on paper and in hindsight, but traditional value investing has always had to stomach its share of uncertainty as a price of its success.

The easiest investing decision to make is to buy great companies when all the news they generate is positive. But don't expect to find too many bargains investing that way.

Buying great companies at great prices, on the other hand, almost always means buying in the disapproving face of conventional wisdom (unless you use options to synthetically enable you to get low entry prices).

Let's look at a couple of examples by way of illustration . . .

Investing in McDonald's - 2012 vs 2002

After MCD's incredible operational (and share price) performance in 2011, it was difficult to find anyone at the beginning of 2012 who was critical of the company's operational results. There were plenty of investors and analyst who felt that the company was fully or fairly valued on a share price basis, but the near universal consensus is that MCD is a globally dominant cash machine, and a true world class business.

That's a far cry from just 10 years ago. Circa 2002-2003, the company was having a rough go of it. Their menu was stae, the CEOs kept keeling over, the company was ridiculed and made to be the poster child for the state of American obesity in moralizing documentaries, and on and on.

The company had clearly lost its way.

But that didn't mean it had lost its structural advantages, strengths that had made it a dominant, consistently profitable enterprise in the first place.

McDonald's the corporation still had the infrastructure, the scale, the brand, the track record of knowing how to effectively market itself to its customer base, and the financial muscle to out advertise its competitors.

That was all key. The difference between a successful turnaround story, and a company in irreversible decline is whether there's actually anything to turn around in the first place, whether the struggling company has any real competitive advantages remaining.

So, if you could pick a year to invest in MCD, which one would you choose - 2002 or 2012?

And to make that decision even more obvious, consider that at the opening bell on the first trading day of 2012, the MCD dividend yield was yielding 2.76% ($2.80/annual dividends on a $101.33/share closing price).

And the effective yield who bought during the problem years? If you'd bought MCD at the opening price on the first trading day of 2002, your effective yield (i.e. yield on cost) would be 10.58% (the current $2.80 annual dividend payout divided by your original purchase price of $26.47/share).

So, in this case, if you'd bought shares of this high quality company back when everyone was laughing at it, you'd be collecting more than 10% in dividends each year from your original investment, and with the expectation of additional dividend growth in the future (plus all that capital appreciation to boot).

Actually, you could've gotten MCD a lot cheaper than that during the dark days of this period - in the spring of 2003, as you can see in the chart above, the stock really bottomed out (as did most of the rest of the market).

Even at $12.50/share purchase price, the 2012 dividend level would now represent an astounding 22.40% effective (or yield on cost) annual dividend yield!

Enter Pepsico and Procter & Gamble

I see a similar principle at work here when it comes to a couple of ther currently struggling but (in my opinion) still world class businesses - PEP and PG.

True neither PG nor PEP has reached the same level of negative consensus that MCD experienced 10 years ago. But both companies have been struggling for a while now to put up numbers that Wall Street doesn't consider disappointing.

For PG, the culprit has been rising commodity prices and an extremely frugal U.S. consumer who is more and more comfortable choosing private label (generic) over branded household products.

And for PEP, the challenges involve a declining North American carbonated beverage market, laboring under the shadow of #1 Coca-Cola, calls for the company to spin off its Frito Lay snack business, and even demands that CEO Indra Nooyi be replaced.

On a sidenote, I documented on this page how I was able to make some great low-risk returns via option selling on PEP in 2010 and 2011 even as the stock slumped.

Remember the Purchase Price

I've pointed out this value investing principle elsewhere on the site, but the purchase price of an investment is far more important that its selling price.

That's because it's not the price differential between the purchase price and the selling price that determines your returns - it's the compounded returns based on your original cost basis that measures the rate at which you're actually creating wealth.

And that's why - if the options market were ever outlawed and I could no longer use options to acquire great companies at bargain prices, and I HAD to revert back to traditional value investing - I would be much more likely to buy PG and PEP over MCD for the same reasons that most investors have been doing the opposite.

So when is the best time to buy high quality stocks? Outside of options-oriented acquistion strategies, I would say that the best time to buy world class businesses is when a majority of investors have stopped believing that those businesses are still world class.

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