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A Lesson Learned on Dollar Cost Averaging

August 29, 2012 | About:
The Science of Hitting

The Science of Hitting

241 followers
Most of my articles as of late have revolved around Staples (SPLS), and I think my activity to date presents an interesting case study that may be insightful for others (it’s always best to learn the bad lessons vicariously).

As I laid out in my August 10 article outlining my contest submission, I believe the company’s intrinsic value is north of $20 per share; at the time of writing, I had already taken a small position in the company, with a cost basis around $14 per share. Since that time, the stock has been pummeled, falling roughly 20% in less than three weeks.

Generally, my strategy is to average down on securities as they become more attractive, particularly if they possess an insurmountable competitive advantage that leads me to believe that any current fundamental (or price) weakness is temporary in nature. With Staples, this is less certain – I’m much more confident about PepsiCo’s (PEP) growth prospects in China over the next decade than I am with the shakeout of office supply retail chains in the U.S.

Of course, none of this is new – I had felt that way from the start, and as such demanded a significant margin of safety (and potential upside) in the case of Staples, where I knew the potential for risk (permanent impairment of capital) was more pronounced.

The recent price action has put me in a tough situation; while the Q2 results were weak, I still feel that the company’s delivery business will continue taking market share, and that the company will be the ultimate beneficiary of retail consolidation. The problem is that I’ve never been as confident in these assertions as would be necessary for me to make it a top holding in my portfolio (on the other hand, I would buy PepsiCo hand over fist in a similar scenario).

The issue comes down to position sizing, particularly as it relates to the remainder of one’s portfolio. When I initially took a stake in SPLS, I was cognizant of the fact that I would want to add on dips, but positioned it too aggressively and left myself with little room to maneuver in the case of a sustained decline while still remaining comfortable with the positions size – and as a result, I have not been able to capitalized on the situation as I would have liked to.

What can be learned from this? I think a couple of conclusions can be drawn:

1) Simply avoid companies that you are not happy to purchase (in a big way) on short-term problems - if you are not happy buying a company when its stock falls 25-30% on pure volatility, then you shouldn’t enter the position in the first place; if you are getting to a point where you’re too committed to a particularly gut-wrenching position, stretch out your purchases when averaging down (my biggest mistake) to leave adequate capital while still staying in your comfort zone (it’s better to miss the bottom tick than to be left with no dry powder while your mouth’s watering).

2) Size your positions accordingly – particularly when initiating them. When you see a tantalizing opportunity, it’s easy to become overwhelmed and act overly aggressive (neurologists have found that the anticipation of financial gain is similar to the brain activity of a cocaine addict); make sure to leave yourself the room to capitalize on further irrationality if the opportunity presents itself.

3) Stay focused on what matters and give investments the necessary time to play out. The important thing is to continue basing decisions upon sound (unbiased) fundamental analysis (an investment journal is a great way to compare your current thoughts with the original thesis).

While I’m not too happy with the way I’ve sized my stake in SPLS, I stick by the analysis presented in early August; time will tell whether or not that thesis was accurate.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.2/5 (35 votes)

Comments

Adib Motiwala
Adib Motiwala - 2 years ago
Thanks for posting. This is an important topic that everyone goes through possibly all the time. The question about sizing, initial purchase, averaging down on an investment that is down 20% or more.

In my Q1 letter, I mentioned often you are disappointed in investing as either you buy too much too soon or on the opposite end you buy too little and the stock runs up. On the selling end, again either you sell too soon or too late....

So, I think buying and selling should be in multiple transactions (say 2-3). You can never pick the bottom or sell at the top. Whether you buy in equal proportions or not is an individual choice.

I have been in a similar position as the author when i went in with a full position. Price drops 20% or more and then you have less room to add. So, now I decided to buy 50-60% of the intended position initially (with exceptions) and then wait for either further drop in price (10% or more) or a period of ownership. The latter may give more confidence about the thesis playing out and you can add to the position even at slightly higher prices ( as long as margin of safety is sufficient). If the stock runs up and you cannot add, you can feel happy that you were right and bought a decent sized position. If the stock drops, then its perfect and you can add with more knowledge about the business.

On 3) giving time is important. Patience is key. From my experience, it does seem that 2 years is plenty of time for most ideas to work out, possibly 3...unless its deep deep value and the entire industry is in a slump and you have bought too soon. However, it is essential to follow the company results and make sure that the thesis is not flawed and the situation becoming worse. This is easier said than done. Often its too cloudy to make this judgement. When the stock drops 20% and the results are poor, it is not easy to always judge if this is a short term problem that is dragging on longer than you expected, or its time to bail on the investment. Averaging down is not an easy and natural choice. Averaging down constantly can be path to serious trouble. (Averaging down on value traps can get your head handed to you. anyone average down RIMM/NOK or the chinese frauds?)

Coming back to the authors point of sizing, if you have regular savings then you can always contribute to that position as your capital base is constantly growing and the size of each position is shrinking on a relative basis

thanks

Adib

waup7707
Waup7707 - 2 years ago
The most infamous averaging-down disaster during financial crisis is Legg Mason's Bill Miller. Miller did dollar-costing on many financial service names all the way to bankruptcy or permanent impairment. He had used dollar-costing and thrived for a long time by beating the market 15 years in a row before falling off the cliff during great recession. He pretty much destroyed the credibility he meticulously built over his lifetime and permanently damaged the franchise of Legg Mason.

Averaging-down can be a dangerous strategy for investing in some industries, such as financial services (WaMu/CountryWide/AIG/C/BAC black boxes, high leverage), retailer (CircuitCity/Borders/SVU/RSH/BBY fast-changing competitive dynamics and consumer taste/behavior), technology (NOK/RIMM/FB very difficult to predict future cash flow).
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Adib,

Thanks for commenting; those are some very helpful thoughts.

Waup7707,

Good point; as you note, the danger comes in the form of value traps that appear to be increasingly attractive investments. It's a tough problem to deal with, and I think the answer comes in the form of caution and limited concentration (I'm talking 15% or more of your funds) in all but the safest opportunities (for example, Warren making American Express 40% of his holdings after the Salad Oil Scandal); thanks for the comment!

BEL-AIR
BEL-AIR - 2 years ago
I always like your articles..

But...

I don't like to pay more than 8 times earnings....

Due to falling earnings, or at least the potential earning could continue to soften a bit more I like some safety...

I had mentioned before on your prevous article on SPLS, that it is much more conservative that SPLS will have an earnings of $1.00 to $1.20 per share, which gives me a larger margin of safety...

8 times earnings of that would give me a buy point of $8.00...

At $1.20, then $9.60 a share.

But I prefer the $1.00 figure in case I am a bit wrong...

But even at $8.00 it is still more than twice Tangible Book-Value...

It will be hard for SPLS to keep getting a 40% return on Tangible Book-Value, so one must watch for that to, 30% or less is much more likely going forward, but even that rate might be a bit of a stretch.

I can't think of many companies that can continue to return 30% let alone 40% return of Tangible Book-Value forever, why should SPLS be any diffrent, everyone finally has their day.

This is how I like to do things.

But this is just me:-)
Cornelius Chan
Cornelius Chan - 2 years ago
Good call BEL-AIR. It is better to be over-conservative than under, basically. If you wait, often Mr. Market will reward you with a lower share price yes? And then, if he doesn't, you didn't even swing so you cant miss right? LOL!! Excellent.
BEL-AIR
BEL-AIR - 2 years ago
Yes you are right Cory....

Wait for the game to come to you...

You know my style to well.

One thing I wanted to mention to you all is this...

I don't feel confortable buying companies with a real high return on tangliable book value...

Particlularly if it is in a sector with such competiveness as SPLS is in...

Since it is not likely to maintain such a high return in the face of Amazon etc...

Really the way I like to do it is never give more than a 15% return on equity on tbv when I value a company in such a industry...

That way it is much less likely I gonna be caught in a value trap...

Since 40% is really gonna be hard to maintain going forward with the economy, compention and all in this sector.

So this is a harder one for me to figure out and value easily. To be sure and confident...

So I need a larger margin of safety on this one to compensate for this, to make me feel more comfortable, so either I get this amount of safety, or I won't get my bat out to swing at this one.

I can't be struck out if I don't swing...

There will always be another stock, next week or the month after, or even in the next market pull back...

Still I must be realistic as well about valuation or I never will swing....

But SPLS has some unknows for me, so I have to stay on the fence untill I am compensated with a larger margin of safety.

Many on here were buying RSH based on projected earnings for 2012, but now that the truth has been seen thru actual earnings and it is now apparent that RSH is likely a value trap... Now it is not looking so good any more.

Better to go by average of last 5 years of earnings to try to keep out of all the value traps...

Before I go, I wanted to mention one more rule of mine, always be very very carefull of companies making 52 week lows while the market keeps marching higher.

It is not often that Mr Market will give you something cheap and easy while the markets about to make new highs, this is were patience comes in and waiting for market corrections, pull backs etc ..


If it were this easy everyone would be rich.

It's tough to do, to invest cheap and to stay out of the value traps, it is something I still working hard on to this day, and has become my main focus of study this last 4 months, how to avoid the traps.

Good article by the way, showing us your thoughts and how you learned as it happens to you Science of hitting...
swnyc2
Swnyc2 - 2 years ago
Dear Science,

Dollar cost averaging decreases the risk, but it also decreases the reward to a similar extent.

If you don't know what stocks to buy and in what amounts, it's a tool that will decrease volatility, but it will not improve your return. As such, I don't think it's such a great strategy.

A more logical (and in my opinion better) strategy is to allocate capital based on where you think you'll get the best return for a given risk.

If you believe you can intelligently allocate capital among various stocks and outperform the market, you should not be so afraid of concentrated positions. I believe it has been shown that the strategy of adding stocks to a diversified portfolio has diminishing returns, especially when the number of stocks exceeds ~8. Therefore, I'm willing to allocate 10-15% of my portfolio to one stock without much concern.

Most people would agree that it's a bad idea to purchase a stock with money that one might need in the short term, because it might force you to sell a stock at an inopportune moment. Similarly, I will not initially purchase a large position in a stock, so that it exceeds 10-15% of my portfolio, because if the stock goes lower I will miss the opportunity to average down. In theory, this might mean that I will not get as large a position as I want, before the stock moves higher. However, in practice this has never been the case, because I never am so lucky as to buy at the absolute bottom.

So how did I deal with SPLS?

On 2/9/12 SPLS was at 14.96 when I read Chulak's article. It was a good article, but I didn't feel comfortable buying SPLS. I waited until the last half of June. At that time, my initial purchases were at an average price of $12.54 and SPLS comprised 3% of my portfolio.

I then read a series of articles you wrote in August both shortly before and shortly after the stock got smashed. After considering the risks and benefits, I was convinced even more than SPLS was a good long term investment. I really believe it has good upside potential and minimal downside risk. (I think they can make their dividend payments, and at 4% yield, I can afford to be patient). If the stock goes much lower, I think it becomes private equity a take-over target.

So, in the last part of August, I tripled my stake (to ~9% of my portfolio). My average purchase price is now $11.39, which is still about 4% below the closing price today. Although I have lost money in the stock as of today, I still think it's a good investment. The purchase of SPLS required me to sell some other stocks to balance my portfolio, but I chose to do it because I thought it resulted in a better allocation of capitol. (Some of the stocks I sold have gone down in price subsequently.)

Science, I'm sharing my experience with you, because I think you did a great job analyzing and writing about the stock. No matter how this investment works out for me, I appreciate you sharing your thoughts. I hope my perspective helps you with regard to allocating your capital in the future.

The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bel-Air,

"I had mentioned before on your prevous article on SPLS, that it is much more conservative that SPLS will have an earnings of $1.00 to $1.20 per share, which gives me a larger margin of safety... "

Not too sure what that means... are you saying you expect $1-1.20 in EPS this year? Would you mind explaining where these numbers come from?

Any particular rationale for 8x earnings? And your commentary on returns on tangible book should come with some caution; it's the equivalent of looking at a company with little/no earnings and an absurdly high P/E and assuming that it's grossly overvalued. There are multiple variables that affect the equity accounts that should be examined before making such blanket statements (if that's all that's needed, one would look at YUM's ROE and salivate...)

Swnyc2,

Smart strategy and good patience; thanks for the helpful commentary - hopefully I'll be a bit more patient next time!

swnyc2
Swnyc2 - 2 years ago
Science,

This just in. It's part of an interview on CNNMoney with the founder of SPLS.

CNBC's Herb Greenberg recently asked if Staples is a metaphor for America, in that it was a once great company that's fallen on tough times. Fair?

I'm not going to comment on Staples because I think that's bad form.But what I will say about the office superstore industry is that it has three or four fundamental challenges that companies need to address.

One if that it's hard to be a technology seller without selling the leading technology company, Apple (AAPL). They've got to get Apple. Two, I think three companies ought to be two. And obviously I put my money where my mouth was way back when but it failed [Staples was blocked from buying Office Depot in 1997]. I think the FTC was wrong, and I think the FTC knows it was wrong and that a merger would be an effective and productive in providing vaue to the American consumer. Three: I think they need to spend more money and effort in passing the Main Street Fairness Act, or some version thereof, so that retailers with physical presence collect taxes the same way Internet retailers collect taxes and thus a level playing field?

-------

I think it's likely that SPLS with get APPL and that the playing field between AMZN and SPLS is getting more leveled with regard to AMZN collecting taxes in more states. As to SPLS buying one of its competitors, I think that's pretty unlikely.

Do you have anything you'd like to add?

Dr. Paul Price
Dr. Paul Price premium member - 2 years ago
Science of hitting,

Not much conviction on your part with SPLS.

This year's earnings are on track to be the Staple's second best ever. That's hardly a reason to give up on their long term business model. Amazon's need to start paying state-level sales taxes will make SPLS even more competetive than previously.

I think your mind has been polluted by the stock price action. You are doubting what you saw (and wrote about) only because the market does not seem to agree.

sapporosteve
Sapporosteve premium member - 2 years ago
Thanks for the excellent article.

Firstly, the first step is that you are learning how to be a better investor and since there is plenty of investment time left, then the importance of constantly assessing your philosophy is a major plus.

I too am wrestling with the same problem and your conclusions are absolutely correct in my opinion.

It is the same position that I have been coming too over the recent past (nice bit of confirmation bias for me). I have some stocks which I want to buy more of but they are also at my full allocation. But they go down further and as you say, I am salivating but keeping my meager amount of spare cash in the kitty.

As I result of buying "too much too soon", my dividend yield is lower and I am sitting at losses on some of my purchases.

I held JCP (partly thanks to your excellent assessment) but it was not a bigger enough position so I sold out with a small gain and put it into others that I think will yield more in the shorter term.

I think JCP is a good long term play but I want to be able to buy a decent portion. Given that the market seems negative, I expect to buy it later at a better price.

In these volatile times, I constantly need to remind myself that it is a business I am investing in and not a stock price. That way I can stay anchored to assessing the business and ignore (partially) the day to day movements of the stock price.

Regards

Steve

sdnarra
Sdnarra - 2 years ago
Science of hitting,

I agree with stocksocx99. I think your analysis was spot on. Of course in hindsight you went in too early, but hindsight is 20/20. I am not sure how deep you are and what your comfort level with risk is, but mr. market sure looks like it is being a manic depressive here. The revenue decline ex international sales was not that bad. Part of the international weakness(about half) was currency related also.

I read your article, both new and old last night and was impressed with the clarity of thought. I then read through the most recent 10q and 10k and looked at the 10 yr trends a couple of different ways. Then I looked at the balance sheet which is quite healthy. The near 7-8% management returned to shareholders via dividends and share buybacks last year, and the now comfortably above 14% FCF yield. Then I looked to see who was buying recently and came up on the name of Yacktman who initiated a position recently and quite likely is adding on weakness.

This company had brand equity, is entrenched in its niche, and lots of scope to restructure and consolidate and cut costs if that becomes necessary to maintain FCF yield, it is selling at book value and there is a significant margin of safety here. It did not even hit these prices during the depths of the great recession I think the lowest it went was $14 or so, at that time its peers ODP broke a buck and OMX went to about $2.

I feel Mr Market is offering up a great opportunity here and initiated a 2% of my portfolio sized position today, although I am bearish on the overall market and recently went to 40% cash I felt this current price compelling enough.

I hope your risk tolerance and portfolio size allow you room for a little more entry. Even otherwise, You will likely make a decent return just waiting it all out.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Thanks for the great comments; always better when we get a lively discussion going.

Let me be clear about something that it appears I left some uncertainty about: I feel just as comfortable with this company as a I did when I wrote my original analysis - and once you consider the big decline in the share price, I think it is an even better investment.

My purpose for writing this article was to highlight my overly-aggressive accumulation strategy; going in, I knew I would never be as comfortable with this holding as I am with a PepsiCo or a Berkshire - while I think Staples holds a sustainable advantage in the delivery business and will be the main benefactor of the tailwind from ODP/OMX closures and downsizings, I'm less confident about what that means a decade from now than what PepsiCo will be doing in 2022.

In terms of Amazon, sales tax will be here soon - in California, for example (one of SPLS largest markets), AMZN will start collecting sales tax in September unless Congress takes federal action before (unlikely).

Again, to avoid any misunderstanding (and as I note in the last line of the article) - I stick by the analysis presented; I just don't have the conviction (nor did I ever have the conviction) to make SPLS 20% of my portfolio (BRK.B is my only 20%+ holding at this time).

Dr. Paul Price
Dr. Paul Price premium member - 2 years ago
I don't know how long you've had BRK but the 'b' share equivilents traded as high as $101.20 in late 2007 versus $84.20 this morning for an almost 5-year loss of more than 16.5%. and no dividends along the way.

Even BRK needs to be traded occasionally to have a good chance at making decent profits. Being 'comfortable' with it wouldn't have saved you from a negative 4 2/3 -year total return.

swnyc2
Swnyc2 - 2 years ago
Science,

[size=13px; " style="font-family: Arial]I understand your concern about increasing your stake in SPLS. However, I don't think you should have a hard limit. It's all about risk reward. If SPLS were to trade at $7 per share today without good reason (in your opinion), perhaps you'd be willing to raise your stake? All I'm saying is that if it continues to fall, don't be afraid to increase your stake.

On another note, someone pointed out to me that SPLS has an intangible assets ratio of 33%.

That seems kind of high. I was wondering if you had any thoughts on that?

Did they make some bad acquisitions in the past?

What are the chances of a substantial write down in the future?

Regards,[/size]
The Science of Hitting
The Science of Hitting premium member - 2 years ago


Stockdocx99,

My cost basis is $71 on BRKB; I started buying in mid-2011 and loaded up when it temporarily fell in the mid-60's. I won't comment on where it was in 2007, but I'm still salivating at the current valuation...

In terms of trading BRK.B to have a good chance at making decent profits, I think Warren's financial position and investment strategy suggests otherwise.

Swnyc2,

Sorry I missed your earlier comment; on Herb's commentary, I'm not quite sure what he's looking at - he's talking about the company barely being cash flow positive, when in reality FCF will exceed $1 billion this year. I honestly believe that these guys have not looked at the industry as a whole and have no idea about upcoming lease expiration and the store closure/downsizings on the horizon.

As I noted above, sales tax changes will happen on the state level if no federal action is taken (with California, home to 14% of SPLS domestic stores, coming on line next month); we'll see what happens with that legislation in the coming months, but I expect a federal change relatively soon (with WMT, TG, etc making sure that brick-and-mortar retailers don't get the short end of the stick).

On a continued fall in the share price (and no fundamental change in the business), I would be a buyer - and that's the point: I should have been a bit more selective with my purchases to leave myself room to keep buying while still staying comfortable with the positions size compared to my overall portfolio (at some point, I will not be a buyer - I don't want SPLS to be 40% of my portfolio).

In terms of intangible assets, $3.55B came from the Corporate Express acquistiion in 2008; in 2009, the acquisition added $2.3B in revenue to NAD (established Canadian Contract business for SPLS) and $1.9B to International Operations (Europe & Australia). Quantifying the potential for a write-down is difficult because the business isn't broken down to that level of visibility (tough to tell what changes in NAD are directly applicable to the Corporate Express assets).
sjzhao2003
Sjzhao2003 - 2 years ago
Science,

Thanks for sharing your experience. I'm sure a lot of us have had similar experience. I often use the following simple steps to deal with it:

1) Rank order all my current holdings and potential candidates in terms of my expectation for their future return for the next five years (if I don't have a strong conviction about a stock or if its expected return is below BRK, it won't be considered at all).

2) I'll be interested in buying a stock only if it ranks near the top and clears my hurdle rate by a comfortable margin. If i have a large cash position, use cash; if not, sell those current positions that promise much lower returns.

My own experience is that whether the price has dropped or jumped since initial purchase made no difference whatsoever. I've done both averaging down and averaging up, though more often averaging down. The only question is, does it promise a high return that i can be sure of?

Although I don't have a preset position size, I've tended to regret not being aggressive enough in purchases, after the stomach churning from watching your stock going down. In a way, without preset sizing rules allows the best "athletes" to win.

Good luck!

waup7707
Waup7707 - 2 years ago
The value of a business is all about the sum of discounted future cash flow. If revenue and profit margin is perceived to be trending down, the value of the business will be greatly discounted. On the TTM P/E basis, the good examples are BBY (4.5), Dell (6.3), RIMM (1.8).

What is the probability that SPLS sales/profit will be lower 5-10 years from now? 45% of SPLS revenue (business machines 30%, computers and accessories 15%) are similar to BBY. Even it's North America Delivery business (40% sales) needs to fight with fierce competitors. I can think of two big threats, 1. Xerox (TTM PE 7.8): in print, paper, office supply delivery. 48% of Xerox's 22.6 Billion annual sales is in business services. 2. Costco: I worked for two Fortune 1000 companies and both used Costco to fill their break room and office supply needs. Every other week, the admins go to Costco to pick up supplies. Small and medium size companies are even more likely to use Costco to cut supply cost.

I don't feel comfortable about SPLS even at current "low" price (TTM PE 8.0).
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Waup7707,

Those are good points; every investor must analyze the information on their own and determine whether or not they're comfortable with the valuation/business model. Thanks for commenting!
waup7707
Waup7707 - 2 years ago
The good thing about listening to disconfirming viewpoints is that you may need to revise your thesis for better or you can have even stronger conviction if you believe you are right. If your idea can not be killed with rigorous stress test, it might qualify as a good investment.

I am always looking forward to opposing views that can help to refine my investment acumen.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Waup7707,

Agreed! That's why I love the active commentary from reader's on recent articles!
edyouds
Edyouds - 2 years ago
Intresting and I took a position in SPLS. I am from Australia and owned Corporate Express (CE) in the past and I always thought at the time that SPLS had over paid for the acquistion. CE already had a dominant market share in Oz so organic expansion would not have been possible. I think your posts are great and well thought out. Keep them coming! Ed

The Science of Hitting
The Science of Hitting premium member - 2 years ago
Ed,

Would love to hear more about the industry in Australia (if you have any particular insight); thanks for the comment and the kind words!

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