What fund managers can teach you about buying into a share

Have you ever thought about how a big investment fund buys into shares? Imagine this, a fund like the Ninety-One Value Fund has R6.5 billion invested in various company’s stocks and bonds. If you consider only its largest investments, it is invested in at least 23 stocks, and then there’s a string more that it is invested in at levels below 1% of the fund value…

So how does a fund like this buy into a stock? And what can you learn from it?

How a big fund buys into new stocks

Fund managers will have a team of analysts researching stocks for them. And not only do they spend a lot of time researching individual stocks, but also how to construct their portfolios. That is, how much of each stock to buy… But these funds don’t simply click the buy button on a stock like we do once we have picked one.

Consider Ninety One’s portfolio for a moment… The fund owns a small cap company called Hulamin. In a past quarter it owned R153 million worth of the stock. Over the past month, Hulamin’s average trading volume hit R1.36 billion. That’s just over R45 million per day.

Clearly funds don’t buy all the shares they own all at once. What actually happens is the fund manager gives their trading team instructions to buy up to a certain amount of shares, below a specific price (that would be based on the valuation of the stock).

The traders then have the job to start buying shares in the stock, bit by bit without pushing the share price up. You can just imagine what would happen if they entered a R45 million order in the market on a company that is worth R1.3 billion. The share price would shoot through the roof, and they would be unable to buy.

But if they bought smaller amounts of R100,000 here, and R200,000 there they’d easily buy R20 million in a month without moving the share price significantly.

Three lessons you can learn from investing like the big funds do?

There are three lessons you can learn from the big funds:

1. Do your research and invest in high confidence opportunities

You should do your research and understand the drivers of a company before you invest in it. Just think about it, these funds invest in stocks they have such a high conviction in that it takes them months to buy into a position. That also means they can’t simply sell the stock willy-nilly…

Make sure you read the article on Wednesday on stock picking tools on how to find stocks to invest in… Otherwise if you can’t be bothered with doing your own research, then check out MoneyMorning’s Tip of the Day where the research has already been done.

2. Decide on position sizing before hand – and take calculated risks

Small Cap stocks are volatile. That means their share prices can fluctuate wildly. You need to be prepared for that. And part of that preparation is ensuring you don’t invest so much in a volatile share that these fluctuations keep you up at night. There’s no rule of thumb here, based on your net worth and personal situation your risk appetite will differ.

If I invest R100,000 in a share and it drops 20% I would sit on a R20,000 loss. I might be comfortable seeing a R20,000 loss in my portfolio, but the next guy gets twitchy when a share is down R5,000…

In penny stocks you need to be prepared for a 20% loss as part of the fluctuations a share can make. That means – if you can stomach losing R1,000 you shouldn’t invest more than R5,000 in a share. If you can stomach losing R10,000 you can invest up to R50,000 in the same share.

It is important to figure this out for yourself. Looking at the share’s chart you can also get a feel for its volatility, adjusting your position sizing on how volatile the share could be. If it tends to have bigger swings, invest a little bit less. If it tends to make smaller moves, invest a little bit more.

3. Average in over time – sticking to the share’s valuation

When a fund buys into a stock they do a valuation like our profit target on a stock. They then decide at what level to buy in at and will not go higher than that price. That’s why they buy into these stocks over time, to ensure they don’t spike upwards too much.
Similarly – you should stick to a buy level on a share. Try not to get swept away in euphoria when it suddenly rises a lot. But here’s the thing, using an online broker with low brokerage fees you can buy into a share in smaller tranches over time, without the costs affecting you too much.

For example – Let’s say you had decided to buy KAP Industrials . Let’s say the share price was 300c, you were willing to buy in below 340c. The target price was 930c. You were willing to buy up to R10,000 – R15,000 per share.

First you start out by buying R5,000 in KAP at 300c (1,666 shares). The share spikes and hits 395c, and you don’t get another buying opportunity. But later it drops to 280c, and you buy a further R5,000 worth of shares (1,785).

This means the average price at which you bought is now 290c per share.

Let’s say the share then goes up to 450c. That’s a gain of 55% on your average buying price of 290c. If you bought ALL the shares at 300c, your gain would be 50% – a difference of 5%.

But let’s say the excitement of the share price rise got the better of you, you ignored the buy levels… So, you bought R5,000 worth of shares on 300c.

Then on 1 March the share price soars to 350c, you can’t resist, and buy a further R5,000 worth of shares at 350c (1428 shares).

That makes your average buying price 325c. Suddenly your gain is only 38% – that’s 17% less!

I have a warning for you though…

Firstly – averaging into a lower share price only works if you limit your initial investment, and plan to buy on dips (and remember, sometimes the dips don’t come).

But if you invested the full R15,000 you’re willing to risk in a share outright, it is not a good idea to buy more if the share price drops. Then, if the share does continue a downward spiral, you will lose heavily.

Secondly – you have to understand what the positive and negative drivers are behind a share. The catalyst you identified when buying into it should still be valid if you want to buy more of the stock. Similarly – if there’s a big driver behind the share price falling, instead of market volatility or sentiment, you should avoid buying more. This would be something like a huge recession, crashing car sales or the like.

Use these lessons wisely and you can make excellent profits in the long run! Real Wealth focuses on investing for the medium term in high income stocks so this approach can be very effective. If you want to join my members list just go here.