Do You Average Down? Guru Strategy Series (I)
In Prem Watsa’s latest annual shareholder letter, he shared one of the secrets of his 33 years of successful investing: to average down when buying and average up when selling.
As an example, Mr. Watsa shared his experience with International Coal (ICO). He started buying the stock at $4.58 a share in 2006. He bought 21 million shares at the cost of about $4.5 a share. The stock then dropped all the way to $1.2 a share, and he bought another 24 million shares at about $2.5 a share. Eventually the stock price recovered and he started selling at $7.26 a share — he sold most of his shares at $14.6 a share.
The question today is: Do you average down when buying?
Averaging Down Can Be Rewarding
Averaging down is clearly something technical traders will not do. A “stop loss” will automatically sell a stock if the price drops to a certain level. To them, stock prices have only one direction. But averaging down is clearly something that value investors should do. You have already bought a stock at higher prices. When the price is lower, why don’t you buy more?
If you buy the stock at half the original cost, your chance of making a 100% gain is much higher. Averaging down is very rewarding, as also shown in Mr. Watsa’s example of International Coal. If it is so good, why doesn’t everyone do it?
Averaging Down Is also Scary, and Potentially Disastrous
In Mr. Watsa’s example, he initially bought International Coal at $4.5 a share, and the stock price collapsed to $1.2, a 75% drop. A 75% drop does not mean it cannot drop another 75%. Are you scared?
Sometimes averaging down can be punishing and disastrous. It can also ruin one’s career. Bill Miller, former star manager of Legg Mason Value Trust, built his 15-year streak of beating the market largely based on averaging down. He famously discussed his investment in Tyco in the year 2002. When he was asked what the lowest price at which he would continue to buy the stock, as the stock price continued to drop, he said zero. Bill Miller was rewarded handsomely with his averaging down in Amazon (AMZN) and Nextel.
Fast forward to 2008, Bill Miller was no longer that lucky. He continued to average down on financials like Washington Mutual, Fannie Mae, Freddie Mac and Bear Sterns. All of those went to zero. Bill Miller was ultimately ousted by the fund. It was an unfortunate ending to his career.
Averaging Down Can Be a Luxury
Sure, you are a true value investor and you want to average down as stock prices decline. But do you still have cash?
Individual investors are luckier on this than the professionals. Individual investors can continue to generate cash through their jobs or businesses. But those who manage other people’s money for a living do not have this luxury. They usually do not have cash when they need it the most. They may be forced to sell stocks when it is exactly the time they should be buying.
Just ask Bruce Berkowitz. Over his career he has always tried to keep at least 30% of his fund in cash. He aimed to use the cash to buy the stocks that he wanted to buy at lower prices. But he faced extreme redemptions in 2011 as he had his worst year with the fund. He had to sell financial stocks such as Citigroup (C), Regions Financial (RF), etc., exactly at the time he wanted to average down. One of his largest holdings, Bank of America (BAC), dropped to around $4 a share. He loved the company and his original purchase price was far higher. He wanted to buy more, but he had no more cash. Just to see, the stock climbed almost 150% since.
The Key Is to Get It Right
The key in averaging down is to have enough confidence in the stocks you want to buy. Carefully do your homework before you start to buy. Some rules of thumb:
· Buy simple businesses. A simple business is much easier to understand and build confidence in.
· Buy companies with low debt or no debt. Peter Lynch said that a company without debt cannot go bankrupt. How true that is!
· Write down why you are buying this stock before you buy. The “Note” function in GuruFocus’ portfolio tracking tool can be very useful for this purpose. It was actually developed following Peter Lynch’s advice.
· Think ahead about what you will do if the stock price drops 50%.
· Watch the insiders. It is certainly a positive sign when a company’s executives start to buy its stock when the stock price collapses.
An example here is Bio Reference Lab (BRLI). This is a company with a simple business, strong balance sheet and the Predictability Rank of 5-Star. At the price of $19, BRLI was in the top of the Buffett-Munger Screener. But the stock price quickly dropped to below $12 in November 2011. At that point, the company announced a share buyback. The CEO, CFO and COO also bought shares in December at $14 a share. Since then the stock price has doubled.
Please share with us your experience and thoughts with averaging down.