Wednesday, December 29, 2004

200 DMA and downside protection

Over the last 2/3 years I found one particular comforting aspect of picking stocks after their fall from grace (assuming that they are not on their way to Chapter 11). While 2/3 years is definitely a very short period to draw conclusions about price behavior, it does seem like building a bucket of such stocks provides a good downside cushion during the regular pullbacks of the overall market. i.e these undervalued shares tend to fall by a smaller amount than the rest of the market. This will most likely hold over even longer terms as long as these picks don't fall into the wildly speculative category.

It is still possible that a shock, whether it be a long-term recession following a crash or a 9/11 like tragedy, will cause these seemingly cushioned picks to break the lower threshold and drop sharply. Haven't seen it happening, but that the strategy may indeed be a double-edged sword.

The 200 day moving average (DMA) provides a great way to make sure that one is not overpaying for a takeover/turnaround bet. It should also help you to avoid buying at or close to 52-week highs. Occasionally, a buyer is willing to pay a premium that over and above the 52-week high, but that should not make you give up this hard rule about value. Given that buyers have used the 200 DMA as a benchmark when they decide to make a bid, buying a stock below the 200 DMA should be part of your timing strategy. Ofcourse, by itself the 200 DMA is worthless - make sure that there are other strong supporting facts like insider buying, a low price-to-book ratio and a dividend yield.

The takeover, earlier this week, of Meta Group (METG) by Gartner is a good example of the exception where a buyer pays - overpays - a premium over the recent highs! Gartner paid a 54% premium over Meta's most recent and 52-week high price in an all-cash deal. While I had been watching Meta Group for a while now and even recommeded it to a few friends, I could not convince myself to buy it given its high price. I was wrong on this one - but I am not allowing it to change my buying policy.


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