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A Special Support in Value Investing




Continuing our series on value investing, when you’ve identified a company to add to your portfolio, the quest for value may take you in an unusual direction. Let’s assume you’ve evaluated a company’s fundamentals and determined the price you’re willing to pay, which is based at least partly on its discounted cash flow or the present value of the dividend income you estimate it should provide in the future.

If the market price is higher than what you’re willing to pay, exercising patience — an essential component of value investing — obviously is often the smart choice. While you wait, you may learn even more about the stock by examining recent patterns in its price. If you do, you’re likely to discover that the price has moved up and down within a clearly defined and often fairly narrow trading range over a period of weeks, months or even longer. (Since you’re not a day trader, you’re not interested in what happens second to second or minute to minute.)

Home on the Range

In brief, here’s how that range is established. As investors buy, the price rises toward its highest recent top price — let’s say it’s $52 in this case. At some point the number of investors willing to pay as much as $52 is smaller than the number of shareholders willing to sell, so the price moves back down. The same thing happens in the other direction. As the price moves lower, it reaches a point — say, $48 — when investors begin to buy. The increased demand begins to move the price back up.
   
The high point of a stock’s trading range is described as its resistance line and the low point as its support line. Resistance in this sense means that for whatever reason — which varies from stock to stock and from time to time — investors simply aren’t willing to pay more. Similarly, support means that in the eyes of investors, the price is as low as it needs to be to justify a purchase. Of course, that may be too high for a value investor who has set his or her own price ceiling.

A stock’s trading range, while recognizable, isn’t fixed. A stock that has encountered resistance at $52 might break through that line and trade at $55 before demand slows. Or support might falter, the price perhaps dropping to $45. These may be isolated incidents, reflecting a sudden surge or drop in the market as a whole, or some major development — good or bad — at the company itself. But if the new high or low occurs more than once within a limited period, it may signal a shift to a new trading range. 
   
If both the resistance and support are higher in the new range — say, $49 to $56 instead of $48 to $52 — this shift may indicate investors are bullish about the stock. If those lines are lower, investors may be bearish.

Behind the Lines

If you’re a growth investor, you might interpret a drop below the current support line as a sign it may be time to sell, fearing the price will continue to fall. You might want to revisit your stock study in any case to see whether your original assumptions are still valid — perhaps it’s an opportunity to acquire more shares. Just keep in mind that for the long-term growth investor, a stock’s price is driven by earnings, and the price the market is paying today for a stock has nothing to do with what it will pay tomorrow.
   
But if you’re a value investor, a new low, especially if it recurs, can signal that the time to buy may be approaching. It’s likely the price will drop even lower — hopefully within your target range — before rebounding.
   
In fact, by concentrating on the support line rather than the resistance line, you avoid at least one potential problem with this technique. That is, by using a newly higher price as a buy signal, you risk having seen the pattern too late, when the major gains are already history and the price you pay is the new top.

Not Too Technical

Technical analysts concentrate on charting price movements to determine when to buy and when to sell without regard to the intrinsic value of the underlying company. But you, as a value investor, can use price patterns to supplement your fundamental research that established an appropriate price by helping you to anticipate when that price may be available.


Virginia B. Morris is the Editorial Director for Lightbulb Press.


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