Some investors think they lower their cost and reduce commission fees by investing in lump sums. I find that I save more money by making multiple purchases and averaging in at what I think are opportune entry points. However, there are situations when you’d want to buy in a lump sum.
Above-average volatile stocks should be bought in small bites
This is especially true if the stocks in question are more volatile in nature, such as energy stocks. In particular, small oil and gas producers’ share prices move more or less with the underlying commodities’ volatile prices.
Some analysts started buying Spartan Energy Corp. (TSX:SPE) when it broke under $3 per share. However, the shares of the oil-weighted producer have since fallen more than a third to below $2 per share in half a year. It can’t be helped when the WTI oil price continues to fall.
Spartan’s most recent guidance for this year was to generate $42 million of excess cash flow based on US$50 WTI oil. However, the oil price is below US$45 today. So, even though Spartan expects production-per-share growth of 11% this year, the lower oil price will still be a drag for the company.
If you’d followed the analysts and bought a lump sum at, say, $2.80 per share, your cost basis would be much higher than if you started a position then and bought more at current prices.
If you buy the same dollar amount both times, your cost basis would be 14% lower by buying in small bites. Even after you account for commission fees, you’ll still get a lower average cost basis.
What’s the valuation of the market?
No one would argue that the North American equities markets are relatively expensive based on the valuation today. Some would even say the markets are at least fully valued.
However, you may still find discounted or reasonably valued stocks, even though they have dwindled in number. In an expensive market, investors can consider taking small bites in these stocks.
Inter Pipeline Ltd. (TSX:IPL) looks reasonably valued after the recent pullback. At about $25.50, it trades at roughly 10.4 times its estimated cash flow for this year, compared to trading at a normal multiple of 12-15.6 in the last few years.
Inter Pipeline offers a compelling yield of nearly 6.4% with a sustainable payout ratio of about 61%. Investors can consider taking a small bite here, get a nice yield, and buy more shares if they decline further.
You’d buy in lump sums when the market tanks and there are lots of quality bargain stocks for you to choose from.
For above-average volatile stocks and in a relatively expensive market, you can do yourself a service by averaging in to your positions instead of buying in a lump sum.
In application, most people don’t have lots of cash lying around anyway. Most likely, you’ll have income coming in from your job every month, a portion of which can be invested. This fits well with the “taking small bites” strategy.
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Fool contributor Kay Ng owns shares of SPARTAN ENERGY CORP.