When is it OK to violate your cost basis to buy more shares of a company?

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Here’s our Club Mailbag email [email protected] — so you send your questions directly to Jim Cramer and his team of analysts. We can’t offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries. This week’s question: The cardinal rule of discipline is to not violate cost basis and show patience to buy more high-quality stocks on pullback. How do you evaluate a flying stock which might not come back to levels of cost basis to add more? Recent examples include Nvidia (NVDA), Eli Lilly (LLY) and Tesla (TSLA). — Thanks, Ravi Great question. Let’s start by considering why we have this rule to not violate cost basis . The idea is to build a position in a stock by buying on dips. A stock at a lower price — but the same earnings estimates — is a good deal. You’re paying a lower price on the same forward earnings, a lower price-to-earnings multiple. However, there is an exception to the cost-basis rule. This occurs when a stock shoots upward before we can build our full position. Since we are not anticipating the stock breaking below our cost basis — it is rallying — we need another way to determine when to buy more shares. Our two best options are valuation and technical analysis. As fundamental investors, we tend to focus primarily on valuation. The understanding that price is what you pay and value is what you get can help determine a buying point. If you can’t buy below you price basis, you should buy at or below your valuation basis. In this way, you can rest assured that you are getting an equal or better value than you did in the previous buy. Take Nvidia. If you bought shares in the chipmaker in February, you paid about 50 times forward earnings estimates. On Friday, shares trades at about 30 times future earnings. Granted, that February valuation ended up being way off the mark, as earnings came in much stronger than expected. But still, based on valuation alone, we can say shares are a better deal today than they were in February. And that’s after the stock’s massive rally since then. This is what’s called a fundamental reset. Nobody really understood just how big the generative AI opportunity would be for Nvidia. We do now, which means reassessing the stock with this new information. The fundamental drivers of Nvidia’s earnings are even stronger than previously thought, so we can justify paying a higher price. You can use other valuation methods, too. For example, a higher p/e multiple may be justified if there is a new growth catalyst — like the need to reconfigure the world’s data centers for AI workloads. In this case, the company’s PEG ratio (p/e ratio divided by its earnings growth rate over a period of time) would fall, creating a good level to buy. If you violate basis, it’s best to do it methodically and over time. After a fast move up, give the stock time to consolidate as traders flip out of the stock and longer-term investors reassess their next step. And then set up points to buy when the valuation goes lower, just as you would when the stock price falls. You can also loop in some basic technical analysis , but keep it simple. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Nvidia CEO Jensen Huang,speaks at the Supermicro keynote presentation during the Computex conference in Taipei on June 1, 2023.

Walid Berrazeg | Sopa Images | Lightrocket | Getty Images

This week’s question: The cardinal rule of discipline is to not violate cost basis and show patience to buy more high-quality stocks on pullback. How do you evaluate a flying stock which might not come back to levels of cost basis to add more? Recent examples include Nvidia (NVDA), Eli Lilly (LLY) and Tesla (TSLA). — Thanks, Ravi