26Feb 2016

Averaging Down the Investors Dilemma

 

@conkers3 and @wheeliedealer have decided to combine their investing experiences to write this article. We hope that it helps all readers that find themselves faced with the investing dilemma of whether to average down.

Year to date Private Investors, Institutional Investors and Fund Managers have all been shell shocked by the volatility and the worse yearly start to Financial Markets since the onset of the Great Depression. This has left many investors scratching their heads. Should they reduce equity exposure, go to all cash and wait for the markets to stabilise or should they average down into those holdings that have declined?

With each and every investor having a different number of holdings, portfolio valuation and risk tolerance, it becomes an individual evaluation that must be made early rather than in the eye of the storm.

Averaging Down

The Average Down is one of those Stock market ‘tricks’ that gets a terrible press. WE see it everywhere –

“Never Average Down”

“Averaging Down is idiotic”

“Only those taking higher risks like Wheelie Average Down”

“Never attempt to catch a falling knife”……you must have seen similar.

And on the whole, WE have to agree that Averaging Down CAN be a really, really Dumb idea. However, contradictory as it is , WE don’t think that is always the case, and there comes a time and a place for the Downwards Average.

There are really three categories of the ‘Average Down’ that we wish to explore further below – firstly after a Series of Profit Warnings; secondly as a result of the usual Market Ebb and Flow, and finally with regard to Funds.

After a Profit Warning or Three

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking dynasty , is credited with the famous investing quote “The time to buy is when there’s blood in the streets.”

When thinking back over long and painful Investing Careers, we realised that we have Averaged Down a lot of times and when we have done it carefully, it has worked out superbly and made a lot of extra cash. Holding Astra Zeneca since 1994 is a great example of this.  However this comes with caveats:

1) NEVER Average Down straight after a Profit Warning. The problem is that Warnings tend to come in multiples – rarely is there just the one. Usually you get three before the company actually gets on the mend – and quite often this coincides with new CEO and Chief Financial Officer (revered Turnaround Specialist).

2) ONLY Average Down when it is clear that the problems are behind the company and things really are on the mend. You need to be extremely careful – if you buy in and the company is still broken, then you will compound your error and you will lose even more money than the pain you have already taken.

3) Averaging Down is only safe and sensible on certain types of Stocks. Thankfully WE tend to buy pretty solid businesses and if they do have a Profit Warning, it is a temporary event and they tend to recover – although it can take a couple of years, which means Money is dead for a long period. But the fact is that after a profit warning or three, Share prices can get horrendously oversold, so when things are on the mend, you can really get some huge gains as the Profits improve and the p/e Multiple expands. It is also the case sometimes that beaten up Stocks following a Warning can become Takeover Targets.  See some examples here: WHEN A TAKEOVER PREMIUM IS NOT ENOUGH! PART ONE http://www.share-talk.com/takeover-not-enough-report1.php

Certain stocks are just plain toxic. I would suggest that anything that is in the WheelieBin (please see the ‘WheelieBin’ webpage http://wheeliedealer.weebly.com/wheeliebin–wheeliewatchlist–little-black-book.html  ) or has the characteristics of a WheelieBin Stock as per my List, is just unsuitable for Averaging Down. You can only do it on proper, solid, Businesses that have just fallen on hard times. The biggest no-no, is stocks with a Big Debt pile – Never Average Down on these as it will go wrong. Most recent examples of this include GLENCORE,  BHP, Anglo-American Plc, RBS, Standard Chartered, AMEC.

The use of the Charts and Technical Indicators are fantastic resources to help you decide when it is Safe and a Good Time to Average Down. The obvious ones are Moving Averages – a Golden Cross on the 50 day and 200 day Moving Averages (this is where the 50 Day moves up and over the 200 day from below) would be a good indication that the Market thinks things are improving and Sentiment is back in favour of the Stock. The 200 day MA is worth watching – if it starts to Slope Upwards after a Downwards Slope and a bit of Sideways, the Market is probably telling you that things are getting better. But you must tie any Charting Signals in with the Fundamental Analysis of the current situation facing the Company. Is there the potential of a positive catalyst within your period of patience? WE see Fundamentals and Technicals as complimentary approaches and used in combination they can be very helpful.

One other point to consider is about how well you ‘know’ a particular Stock or Company. Which is the better Stock to own? A Stock you have only just discovered and really know bug*er all about or a Stock that you have followed for years and years and has just fallen on a tough patch? There is a good case to say that the Latter is a far better place for your money – but you must be very careful.

This is a Risk that the Stoploss Approach totally skims over – there is a huge risk that by using a 10% Stoploss or whatever, you are just getting out of great Long Term Investments that you know inside out and you run the Risk of buying into a New Stock that you really do not know anything like as well.

To conclude on Averaging Down after a Profit Warning or series of them, is that it can work out very well but you must be extremely careful. Averaging Down when you think a Company is fixed, only to find it isn’t, can be extremely expensive and affect your investing psychology.

Averaging Down on a Pullback

@WheelieDealer For myself, I am very much a Long Term Investor, so the Ups and Downs of the market can be opportunities to buy more stock at advantageous prices. Many ‘Traders’ will be chucking their Lunches up as they read this, but I see Investing and Trading as very different – and I know well that Warren Buffett would be topping up on Pullbacks. For more information on this distinction, please click ‘November 2014’ under the ‘Blog Archive’ and look for ‘Are you an Investor or a Trader?’

Let’s clarify what I am saying here. In the normal course of events and in an ‘Ideal World’, I like to Buy a slug of Stock after a thorough dig into a Company and if it starts to move up nicely within a few days, and if the Candle Patterns and my usual Chart Indicators (MACD, RSI, MA, etc.) look favourable, then I will buy more Stock. In these cases, I am ‘Averaging UP’.

However, it is usually the case that a great stock moves in a very clear Uptrend Channel with a distinct Top and Bottom Trendline marking the Floor and the Roof of the Uptrend. So, in this case, if I buy a stock, thinking I have got it pretty good on the timing, but then I find it slips back and has got cheaper, if I am really keen on the stock, and I have ‘space’ within my Sizing Limits for the Stock to buy more, then I will be looking for a chance to Top-up.

It could be the case that my Initial Timing was pretty poor and the stock might fall 15%, but I am looking for clear Candle Signals and other Indicators to tell me that it is turning up again – then I will pounce and buy more Stock – so I might get more Stock at a 10% better price than when I first went in – so I am ‘Averaging DOWN’.

Of course, you have to be extremely careful and try to understand why the Stock has been falling – you need to be all over the News and Bulletin Boards and maybe asking other people on Twitter if they have any idea why the Stock is misbehaving. If you smell a Rat – you have a decision to make – did you get your initial Analysis wrong and should you now Sell and take a hit or are you still very confident that this is a good stock and the Market is just mispricing it? – often it does this in a General Market Pullback. If you have a bit of doubt, but you think it is OK, then maybe it is best to just stick with the Position Size you already have and not to Top-up. You will get plenty of chances in the future to buy more.

Comment by a Twitter follower:  “Averaging down is the best way to lose money. Adding to a winner is the best way to make money. Compound winners. Not losers”

@conkers3 I have stocks in my portfolio that have I held from 1994 (Astra Zeneca) and some that I only purchased in November 2015 (Home Retail Group). My methodology is the same for most stocks, after completing extensive research. I add the stock to my watch list. Then wait to see if the stock enters my BUY ZONE.  With a declining stock this can be above its most recent multi years low or at a deep discount to its Sum-of-Parts valuation (SOTP) and/or intrinsic value.

As a contrarian investor it can often be a lonely road where going against the herd can often lead to many mishaps. However what many investors forget is that one of the investing universe’s greatest investors is also a contrarian at heart. Do you recognise this quote:

“Be fearful when others are greedy and greedy when others are fearful”. 

Yes the famous quote that you often hear when the headlines are about markets being in a sea of red is by the world famous investor Warren Buffett.

Going into all trades, I know that it is highly unlikely that I have timed my entry perfectly.  After all why would anyone want to sell me a bargain stock just before the share price is due to rebound and accelerate into credible profits?  I therefore tend to scale into positions (by which I mean that if I have allocated a 2% weighting for my total portfolio position in a stock. I will purchase 1%, followed by 0.50% and followed by a final 0.50%). This enables me to Average Down until the stock completely finds a base and in the case of a rising stock it enables me to Average Up in a winning stock. I will add at this stage that I also often scale out of positions. Because I don’t know where the TOPS are.

Many investors average both up and down without even realising because they have instructed their SIPP and/or ISA providers to re-invest their dividends.

Averaging Down on Funds

Funds (Unit Trusts(UT), Investment Trusts (IT), Tracker Funds, ETFs) are quite unusual here and have a massive advantage in that they almost Never go bust. In fact, I cannot think of one Fund that has actually gone bust – although I do remember some Unit Trusts after the Dotcom Boom in the dying days of the 1990s that ended up being swallowed by other Unit Trusts – but they didn’t actually go bust. In the Credit Crunch some ‘synthetic’ ETFs got in trouble because their ‘Counterparty’ got into financial difficulties. See my ‘Funds’ page on WheelieDealer2 for more details on these different types of Funds.

Investment Trusts can have Gearing (borrowing, where they use borrowed money to boost their returns), and I suppose if you have a particular IT with a lot of Gearing then maybe it might go bust – so care would be needed here. But, maybe you should be asking yourself why you are buying an IT with a High Level of Gearing anyway? As an indication, I would suggest that any IT with borrowing in excess of maybe 30% of its Market Capitalisation, is probably to be avoided. I would be far happier with 10% to 15% borrowing as a Maximum. Equity investing is risky enough without adding the risk of lots of borrowing on top. Property ITs may be an exception to this and perhaps Higher Borrowing would be OK – it is up to the Reader to decide what level of Borrowing you are prepared to accept – and, if you get it wrong, you must learn the lesson.

Unit Trusts tend to have ‘Mandates’ that dictate that they cannot borrow money or they can only borrow, say, 10% for example.

In a way, this virtually total inability to go bust is a huge and largely ignored advantage of Funds. It is worth thinking about this if you are a Low Risk and nervous type of Investor – it might be worth checking out my ‘Funds’ webpage http://wheeliedealer.weebly.com/funds.html as well. Would you be better off just investing in Funds and not buying individual Company Shares?

So, because of this almost total inability to go bust, you can perhaps take more Averaging Down liberties with Funds than you can with normal Stocks. The simple approach is to Average Down and buy a load more of a Fund when there is a big Drop in the Markets – times like the Credit Crunch and these kind of Bear Markets are truly awesome times to be buying at advantageous prices. As ever, care must be taken and I would suggest that in a Bear Market, where Indexes are just falling mercilessly and in obvious Downtrends, you should wait it out until there are clear Chart signals that the Markets and Fund Prices are moving out of the Downtrends – and even then it is probably best to ‘nibble’ and just buy chunks of a Fund over time – maybe spread over several months or weeks.

@KeithMcCullough CEO, Hedgeye Risk Management famously states “Every fund that has imploded made this same mistake  – averaging down, into bigger mistakes”. He adds when talking about Fund Managers “Averaging down with other peoples money is not risk management”.

I find one of the best times to buy is when you see the Mainstream headlines saying  “Stockmarkets Collapse in Terror over Hungarian Sausage Crisis” (calm down, there is not a Banger Crisis, you don’t need to rush to the Deli Counter just yet) – that is a brilliant ‘Contrarian Indicator’ that markets are about to Rally big time. Mainstream Media is utterly hopeless at giving the Man on the Street financial advice.

Remember, it is at the point of Maximum Fear where Bear Markets turn up to become Bull Markets. Equally, it is at the point of Maximum Euphoria where Bull Markets break and become Grizzlies……..

Similarly to my Ebb and Flow comments earlier in this article, when Markets are generally Trending higher, you can take advantage of any weakness to top up on a Fund – this might be an Average Down.

Key Point

Anyway, the one thing to keep at the forefront of your mind when you are considering an Average Down is BE CAREFUL !!

If in doubt, don’t do it, stick with what you have or Sell out of the Stock.

@conkers3 QUOTE OF THE DAY

“Research is the process of going up alleys to see if they are blind”. Marston Bates.

Zoologist and Writer

Article written by @wheeliedealer and @conkers3

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