The idea is to buy quality companies when they’re priced fairly or even at a discount. However, sometimes we overpay due to our emotions taking control, or for other reasons. In hindsight, I probably overpaid when I bought shares of Canadian Utilities Limited (TSX:CU).
My first purchase was on March 26, 2015 at $39.99 per share. That was a price-to-earnings ratio of over 18. Today it’s sitting under $36 per share and the shares are trading closer to its normal multiple of 16.5. In other words, today’s shares are at fair value.
What to do after overpaying for a company
I knew I wasn’t getting the best value for the price on the first purchase of Canadian Utilities. I’m generally more easy going on the first purchase because it is only a starter position.
For example, if $10,000 is a full position for me, a starter position would be a quarter of that at $2,500.
My second buy was on May 11, 2015 at $36.68 per share. When I averaged into my position, the average cost per share was reduced to $38.34 per share. If I had doubled down, that is, if I’d bought $5,000 instead of $2,500 at the lower price, I would have further reduced the average cost basis.
Great businesses will correct your mistake
I’ve identified Canadian Utilities as a great utility business. In the past it has grown earnings typically between 5-7% per year. So, even if I bought its shares at slightly higher prices, a great business would correct my mistake in a couple of years by growing its earnings. After all, utilities typically earn stable earnings.
Results of overpaying for a company
Based on my cost basis, at worst, I get a 3% dividend that grows at 5% in alignment with earnings growth. That approximates to an acceptable long-term return of 8% in my books. That’s all there is to it! A lower return for the mistake of buying a company at a slightly expensive multiple.
How to prevent overpaying
No matter if your goal is to maximize total returns or income, investors should aim to buy shares when they’re fairly priced or priced at a discount. To prevent buying companies at the wrong time (or rather wrong price or valuation), set the target prices ahead of time. That way, you limit the influence of emotions.
Averaging into a position instead of buying in a lump sum will average out the valuation you pay over time. Further, you can set target prices or target yields of companies you want to buy ahead of time to prevent emotions from getting the best of you so that you can make sound investing decisions.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Kay Ng owns shares of Canadian Utilities Limited.