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Do You Average Down? Guru Strategy Series (I)

March 20, 2012 | About:
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This is GuruFocus’ first piece in a new series about investing strategies learned from the investment Gurus we follow. The series is inspired by Greg Speicher’s 100 Ways to Beat the Market (read the latest piece in the series here). There is no difference in significance in the order of the writing.

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?

Because…

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.

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Comments

batbeer2
Batbeer2 premium member - 2 years ago
Thanks for an article worth reading.

>> The key in averaging down is to have enough confidence in the stocks you want to buy.

Yes !

Also, read more.

I would expect Warren Buffett and other gurus with decades of experience know every single company in the S&P 500 (and then some). They know what's important in that particular business and what is not.

After some adverse event, they simply read about it in the morning paper and understand immediately what the impact on intrinsic value is likely to be (or not). That way they are can leisurely buy after the s#it hits the fan. Sometimes, like with USG, lightning strikes twice and then you average down.
Adib Motiwala
Adib Motiwala - 2 years ago
Good thought provoking article. Averaging down like most things in investing can go either way. If you are confident in your research and know that the drop in price is not warranted or the drop is way more than the change in underlying value, it makes sense to average down. Question is : How many times should you average down? And when do you start to average down? Down 10%, 20%?

As the article presented examples of Bill Miller, it can go horribly wrong even for the most experienced investors. Hence, I do not think blindly averaging down each time and forever makes sense. Maybe have a rule to average down once or twice at most and also keep in mind what is the total investment in the stock as a % of your total portfolio. If after averaging down, the position has become a huge part of your portfolio which is not your usual thing, you may want to revisit this..

Averaging down is easier if the initial position was very small and you have left room for adding to the position. If you start out with a full position, then your choices are limited ( ofcourse as an individual investor, you can add more money from savings over time. Professionals may be limited in this).

Cogitator99
Cogitator99 - 2 years ago
Once you have conviction on an investment, I think you should always average down in case it goes much lower, say more than 20%. But I agree with Adib, you have to set some kind of limit in your mind as to how much you'll put into an investment. (I like to think in terms of dollar value here, and not % portfolio.)

The other good point is, its tougher to average down on cyclicals or companies that carry some sort of catastrophe risk, like the financials. Looking back, the US financials have "killed" more prominent value investors than anything else, so maybe that's a warning for the rest of us.

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
My record of averaging down isn't great. My investing record overall isn't great.

That said, I think there are two things to consider, the nature of the downturn and the nature of the company.

If the downturn is broad based and not company specific, then why average down when you can likely buy one or many of other value propositions and diversify risk at the same time? (With an eye to holding it long enough to make good long-term tax adjusted returns.)

Whether the downturn is broad based (recessionary or company specific, I think you also have to look at the averaging candidate in terms of its potential longevity. Stocks that have short lives and are subject to some sort of obsolescence (technological, taste) may be on their first and last down cycle, whereas others are capable of surviving and even growing in, and coming out of, a down swing in their or their market's prices. Say, if you are certain a tech company has a couple more cycles left in it, you then have to decide if the short term returns will compensate for the tax hit and risk of not being able to then intelligently redeploy the proceeds at the time of price recovery. Opportunities aren't sequential, they don't follow one another but instead mostly correlate.

It's interesting that people write off Bill Miller and Bruce Berkowitz's capabilities because of a poor year or two of returns. Investors like Miller and Berkowitz that can survive, may be averaging down through a longer cycle not apparent to the lay investor. On that note, I love the Japanese market sitting out there being ignored by all. It's got to be the best opportunity for learning about what works and doesn't work. Like the belief that house prices can only rise and never fall, the general assumption is that the S&P, etc. can only rise and never stay persistently down. i.e. it will always recover in a few years. Yet we can look over the ocean and see what has happened in Japan with its two decade long averaging down opportunity. Now, how has averaging down worked over there? Is it eventually going to be the poster child or wonderkind of longterm averaging down? And on a company specific or index scale?
Cogitator99
Cogitator99 - 2 years ago
Good points. I think the assumption though is that there are certain companies in which you have more confidence in, given that you've done your work.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
Except for instances where stocks are bought as hedges, every buyer of every stock has confidence and has done homework, sometimes to the extreme, yet most don't perform well over time. Even insiders don't do exceptionally well. So there is much more to it than confidence and homework. I'm guessing it is what Buffett says, temperament, avoidance of losses and a longer term perspective and optimism.

If you look at mutual fund performance, almost none outperform the market over any length of time. If you look at the depth of knowledge with a couple decades with of 30 to 40,000 annual graduates of the CFA program and the market automation and the screening tools, etc. that have entered the market, one would assume that there now should be an incredible number of investors coming to light having made exceptional returns. There aren't. Even most of this site's "gurus" don't make exceptional market beating returns over 10 - 15 yr time spans. Yet they are among the best at doing their homework. Then there is Buffett and a few others, doing something else.

Moreover, among all us posters and contributors no one reveals their long term performance, just opinions.
achi nfor
Achi nfor - 2 years ago
This is a good article on averaging down. I averaged down most of my current holdings during the financial crisis of 2008. I panicked as things got worse, but refused to sell because I hate to lose. When things later turned around, I felt like a genius, a miniature Warren Buffett. Presently I still average down with prudence, using options rather than stocks. Options provide me with less risk but higher reward.

ecotycoon
Ecotycoon premium member - 2 years ago
I like this technique :) Buy more of a stock you already know that can give you better return, with better margin of safety, than the other options, why not?

Anyone planning to go to the Fairfax annual shareholder meeting next week? Looking for someone to have lunch with after the meeting at the Fionn maccool's :)

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