3 False Reasons to NOT Buy a Stock

This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Rock. He is a passionate investor.

For the past five years, I’ve exchanged a lot of email with many of my readers. One of the main topics of discussion is why do you buy or sell a specific stock?

I’ve spent many years researching the complete answer to this question. After several hours of research and numerous trades on the stock market, I’ve come up with my own set of rules I now follow religiously. The good thing is since I started following these rules, I have enjoyed great success on the stock market and my dividend income keeps growing year after year.

Related: How to get started with dividend investing

I think it’s crucial for any investor to build their own set of rules according to their risk tolerance and investing goals. Without a clear investing process, you’re inevitably faced with this never ending question: when to buy?

Among my discussions with investors, it has come to my attention that not all of them have a well-defined investing philosophy. This leads them to finding false reasons to NOT buy a stock. Here are a few examples of mistakes they make:

#1 The Stock is Trading at a 52-Week High

Many investors think that buying a stock at its 52-week high is a bad move. Technically, the company’s shares look pricey and you may be led to believe that there will be a drop coming so you can enter the position at a better price.

At first glance, the rationale seems to make sense. But I think otherwise and have proven my theory. When I first bought shares of Lockheed Martin (LMT), it was in January 2014. As you can see on the graph below, it was around its 52-week high:

I bought the stock after a +64% ride over the past 12 months and a +88% ride over the past 24 months. If you go back for the past three years, you even get a +100% return (all excluding dividend payments!).

Who would have thought it was a good time to buy shares of this company, right? From January 16^th 2014 to January 16^th 2015, the stock kept going up by 26.86% (excluding dividend payment). Most importantly, during this period, the stock was down only once compared to my buy price and the price was only down by 4.22% .

I bought LMT mainly because it is a sound business with great fundamentals. Following rule #5, I didn’t spend much time figuring when the perfect time to buy LMT was. I knew it was a strong company in a sector I wanted to buy into and I simply used money on hand and made the trade. How many stocks will you NOT buy and watch the train leave the station if you use the 52-week high rule?

When you wait for a stock to go down to enter in a position; you never know if this moment will happen. Worse; if there is ever a drop, you never know when is the perfect time to buy it. Also, keep in mind that when you wait to buy a dividend stock; you also forfeit the dividend payouts in the meantime.

#2 The Stock Shows a Low Dividend Yield

I’m not always popular with my stock picks as many investors believe that I choose low dividend yielding stocks for a dividend growth investor. Technically, a dividend investor should look for a good part of his portfolio returns to come from dividend payouts. How can you call yourself a dividend investor when you buy stocks with yields under 3%… even 2%? I once searched for stocks paying a yield over 3% until I realized that there were many gems hidden under this psychological mark.

For example, two of my stocks pay less than 2% yield. The first company is Apple (AAPL) which I bought when it was in the $400 range and Disney (DIS) which was bought during the summer of 2013 (another stock I bought near its 52-week high).

Related: Is it time to say goodbye to dividend investing?

My best investment amongst these two picks is obviously AAPL which I was lucky enough to buy it at a very low point. But it wasn’t luck choosing a company showing such high potential of growing its dividend in the future:

Even for dividend investors, the dividend yield is not everything. In my opinion, dividend growth is what truly matters. The dividend growth is not only about the past (data you can compile from various sources) but about the future.

Following my first two investing rules, I select companies showing a relatively low yield and great potential of dividend payment growth in the future. If you pick stocks with a strong dividend growth potential, the payout you receive will always be worth more, even after inflation. On the other hand, if you select a company paying a 7-10% dividend yield but struggles to increase it, your payout will be worth less year after year in nominal dollars.

#3 The Stock Has Taken a Beating

I must admit that this reason is not always bad. Many investors have cut their hands trying to catch a falling knife; I’m one of them. I tried with Blackberry (BBRY) and it was a bad mistake. Buying a company in difficulty should not be at the centre of your investing strategy (unless you are more of a gambler than an investor).  It is a risky way to invest, but when you do your due diligence, you can also find gems in this situation.

Related: My 2014 (and final) portfolio rate of return

When I bought Apple, it was after the company’s shares went from $700 to $435… that was quite a drop and now, this is quite an investment!

I also enjoyed great successful stories like buying shares of Seagate Technology (STX) when the P/E ratio was down to… 3.5!

The company had experienced major problems since 2008 due to beliefs that the hard disk business was going to die as the need for new computers had seriously slowed. Plus, a flood in Thailand in 2011 didn’t help the stock to get back on its feet.

However, as you can see on the graph, the stock burst back and it was another of my great trades. Mainly following rule #7 (think core, think growth), I bought STX and kept it for a while and I used my rule #6 to sell it at a good time (even though the stock continued to go higher). At one point, one must know when it’s time to stop taking risk and cash out the profit!

Build Your Own Investing Rules First

As you can see, using a quick reason based on not-so-elaborate rationale to trade or not to trade a stock is an ineffective way to manage your portfolio. It’s important to dig further and establish your own way of investing, your own set of rules. You can start with some inspiration by reading the 7 investing principles I follow to succeed.

What about you, do you have any investing rules you wish to share with us?

Disclaimer: I hold shares of LMT, DIS, AAPL