How to buy on the dips

Buying quality stocks with investment grade balance sheets on major dips when they're mispriced by the market is a 'no-brainer'.

For example, Macquarie Group (ASX: MQG) fell from a 2015 high of $85.15 to below $60 mid-February 2016 – a decline of over 20%. Similarly, BHP Billiton (ASX: BHP) fell from a 2015 high of $34.12 to under $16 early in 2016 – a decline of around 50%.

During the early 2016 sell-off, courtesy of fears over China's share market correction, countless other stocks also found themselves seriously over-sold.

While buying at the bottom, is virtually impossible, you should – everything else being equal – have a good idea of where along a stock's price decline makes for attractive buying.

But remember, it's important to differentiate a buying opportunity for a trader – someone who might be using technical charts to throw-up much shorter-term trading opportunities – and longer term investors, who are buying stocks more on fundamentals than share price momentum per se.

Did anything change?

Firstly, before you do anything, check to see whether there are any demonstrable reasons why the share price may have dramatically fallen. For example, were there any material announcements by the company that directly affect their earnings, did they revise their earnings expectations, did a major institutional shareholder suddenly decide to lock-in its profits or were there any industry-specific developments that directly impact a company's future earnings outlook?

The rollercoaster ride inflicted on McMillan Shakespeare (ASX: MMS) and its shareholders a while back serves as a classic example. The share price fell off a cliff on the strength of serial changes to FBT laws proposed by the then Rudd-led Labor government, but recovered within short order following the victory of a coalition government.

If the answers to the above questions are no – and nothing demonstrable has changed – as witnessed during share market routing at the beginning of the year – market mispricing – courtesy of investor fear – is likely to be throwing up a glad-bag buying opportunities.

In other words, if the share price is falling, while company fundamentals remain exactly the same, then there's every likelihood the share price correction could be short-lived, and to capitalise on it – you may need to act quickly.

Know a buying opportunity when you see it

As a case in point, McMillan Shakespeare's revenue leap 34% to $243.5 million – with underlying net profit after tax but before amortisation of acquisition intangibles up 34% to $41.8 million – at half year. Yet this didn't stop the stock getting caught up in panic selling earlier this year, which saw its share price fall from $14.74 late December 2015 to $11.52 early February.

When savvy investors quickly recognised the underlying value in the stock, the share price bounced back up to $12.85 within short order.

Given that the stock is still trading at a 12.85% discount to its IV, it still looks attractively priced, relative to its projected earnings per share growth; which are expected to climb from $1.05 in 2016 to $1.21 in 2018, while return on equity (ROE) is expected to remain over 20%.

Key checks before buying

Assuming stock fundamentals do remain the same, and share price has tanked inexplicably, the next thing to check is how the company is trading relative to it's a) its peers on a price to earnings (P/E) basis, b) it's intrinsic value (IV), c) against its 12 month high, d) its 12 month target price, e) did the ASX ask for a 'please explain' and was one forthcoming, and f) especially if you're an income investor, the company's typical yield range.

Admittedly, it's not uncommon for quality stocks on the ASX to trade at significant premiums to their IV. But if a stock's share price starts tanking after a stellar performance, it could denote that the market is now concerned that it's overheating.

We witnessed this with Blackmores (ASX: BKL) earlier in the year when the share price in the vitamin supplements company peaked at over $220 a share before hitting some speed wobbles, and bouncing back down to $172.03 – which incidentally is still five times what it was trading at exactly one year earlier.

When to raise a big red flag

When quality stocks suddenly, and without reason start losing a lot of value, you should at very least have them on radar for a potential buy (or sell).

Given that share market mispricing invariably catches the market knapping, the best strategy is to set the target buy price before these dips occur.

Three potential mispricing opportunities

Given the quality of their underlying earnings, potential mispricing opportunities in the following stocks are worth taking a closer look at.

Super Retail Group (ASX: SUL): The share price has fallen from $11.38 on 4 January 2916 to $8.70, while excellent EPS over the last five years is expected to continue, and ROE is expected to grow from 13.91% in 2016 to 16.54% in 2018.

Cover-More Group (ASX: CVO): The share price has fallen from $2.12 on 8 February 2016 to $1.60, while excellent EPS over the last two years is expected to continue, and ROE is expected to grow from 12.83% in 2016 to 17.18% in 2018.

iSentia Group (ASX: ISD): The share price has fallen from $4.93 11 December 2016 to $3.53, while exceptional EPS is forecast, with EPS expected to grow from $0.16 in 2016 to $0.21 in 2018. ROE is also forecast to remain at around 26% until 2018.