The profit is made on the purchase price, not the sale price.
Buying a great company at a “cheap” price secures profit and provides a margin of safety, often referred to as a “dip.”
However, it’s only considered a dip if the intrinsic value remains stable while the market price falls.
It’s important to remember: value is not the same as price. Think of value as the utility that your product or service provides.
Consider a fictional company, NTN, which offers data and voice connection services. Its value lies in the productivity it delivers to users in Nigeria. This value is reflected in its market price. Now, imagine a scenario where Nigeria experiences a port closure, making diesel imports impossible.
This could lead to NTN’s base stations shutting down, resulting in an inability to provide voice and data connections. In this situation, NTN’s price should decrease because its revenues will be affected by the loss of functionality in its base stations. But what about its true value? Has that changed? Not at all.
While the revenue loss is real, it’s temporary and structural. This disruption won’t last forever, and revenues are likely to recover. Holding NTN stock or buying it when the price falls means you’re “buying the dip.” Essentially, you’re purchasing a good stock at a discount because the underlying value proposition remains intact, even if revenues are temporarily paused.
In summary:
If the value is higher than the price, buy.
If the value is lower than the price, sell.
Buying a great company at a premium can result in wasted compounding periods as you wait for the market price to rise enough to cover your initial cost.
To illustrate this in football terms, consider Cole Palmer. He has the potential to be as good as either Messi or Jack Grealish. If you buy Cole Palmer for $40 million and he plays like Messi, he can be sold for $190 million. Even if he doesn’t reach Messi’s level, you can expect his value to exceed $40 million because you bought him at a “dip” which gives you a margin of safety.
In contrast, if you purchase Jack Grealish for $100 million, you have no margin of safety. If he doesn’t perform like Messi, you risk losing money since he won’t be resold for $100 million.
In conclusion, not all dips are bargains. For instance, Philip Osundu was bought during a dip because investors believed he had more potential for growth due to his age. However, he turned out to be a value stock masquerading as a growth stock. Regardless of his talent, there was no margin of error, making the dip he was bought at ineffective.
Another important point: buying the dip is most effective if you plan to hold onto the investment, allowing the stock’s earnings to normalize and the price to rebound.
