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

This is our club mailbag email investingclubmailbag@cnbc.com – so you can direct your questions to Jim Cramer and his team of analysts. We cannot provide personal investment advice. We will only consider more general questions about the investment process or portfolio or stocks in relevant industries. This week’s question: The basic discipline is not to violate the cost basis and be patient in buying more quality stocks on pullbacks. How do you evaluate flying inventory that may not be able to get back to cost basis levels to add more inventory? Recent examples include Nvidia (NVDA), Eli Lilly (LLY), and Tesla (TSLA). — Thanks, Ravi Great question. Let’s first consider why we have this rule that does not violate the cost basis. The idea is to build a stock position by buying dips. A stock with a lower price but the same profit expectations is a good deal. For the same forward earnings, you pay a lower price and a lower P/E ratio. However, there is an exception to the cost basis rule. This happens when a stock moves up before we establish a full position. Since we don’t expect the stock to fall below our cost basis – it’s rebounding – 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. Understanding that price is what you pay and value is what you get helps determine the point of purchase. If you cannot buy at a price below your price basis, you should buy at a price at or below your valuation basis. This way, you can rest assured that you’re getting the same or better value than your last purchase. Take Nvidia as an example. If you bought shares of the chipmaker in February, you would have paid about 50 times forward earnings estimates. On Friday, the stock was trading at about 30 times future earnings. Granted, February’s valuation ended up well ahead of expectations as earnings were much stronger than expected. But based on valuation alone, we can still say the stock price is better today than it was in February. That’s after the stock has risen sharply since then. This is called a fundamental reset. No one really knows what an opportunity generative AI represents for Nvidia. We do that now, which means using this new information to re-evaluate the stock. The fundamental drivers of Nvidia’s profits are stronger than previously thought, justifying paying a higher price. You can also use other assessment methods. For example, if there are new growth catalysts, such as the need to reconfigure global data centers for artificial intelligence workloads, a higher P/E ratio may be justified. In this case, the company’s PEG ratio (price-to-earnings ratio divided by earnings growth over time) will fall, making it a good buy level. If you violate a fundamental principle, it’s best to do it methodically and over time. After a rapid rise, give the stock time to consolidate as traders sell off the stock and long-term investors reassess their next move. Then set a buy point when valuations move lower, just like when stock prices fall. You can also loop through some basic technical analysis, but keep it simple. (See here for a complete list of stocks in the Jim Cramer Charitable Trust.) As a subscriber to Jim Cramer’s CNBC Investing Club, you will receive trade alerts before Jim makes his trades. Jim waits 45 minutes after sending a trade alert before buying or selling stocks in his charitable trust portfolio. If Jim talked about a stock on CNBC TV, he would wait 72 hours after issuing a trade alert before executing the trade. The investment club information above is subject to our Terms and Conditions and Privacy Policy and our Disclaimer. No fiduciary duty or obligation shall exist or arise upon your receipt of any information relating to the Investment Club. No specific results or profits are guaranteed.

Nvidia CEO Jen-Hsun Huang speaks during the Supermicro keynote during the Computex conference in Taipei on June 1, 2023.

Walid Berazeg | Sopa Images | Light Rocket | Getty Images

This week’s question: The basic discipline is not to violate the cost basis and be patient in buying more quality stocks on pullbacks. How do you evaluate flying inventory that may not be able to get back to cost basis levels to add more inventory?Recent examples include Nvidia (NVDA), Eli Lilly and Company (LLY) and Tesla (Tesla). — Thanks, Ravi