“Warren Buffett says that the best investment course would teach just two things well – how to value an investment and how to think about market price movements.”
Joel Greenblatt, writing in The Most Important Thing Illuminated by Howard Marks
Market and share price movements are as integral a part of any investor’s life as breathing and, whether we like it or not, some of the time these movements will be downwards. When that happens, you have two options – react emotionally and unthinkingly run for the exit or react like a value investor and coolly appraise to what degree the investment case has changed since you first bought in.
It may be you conclude the right course of action is indeed to head for the exit or else that you should do nothing – and, as we have discussed in articles such as Inaction stations, that can prove to be the best plan a lot more often than most investors are prepared to accept. Or you may well decide the investment case has not changed all that much, which means a lower share price is a great opportunity to buy more of the company.
The technical term for acquiring further shares in a company after its price has fallen because you believe in its long-term investment case is ‘averaging down’. This is because the process of buying more shares at a lower price than your original purchase brings down the average price you have paid for the total number of shares you now own. Also known as ‘doubling down’, you can read more about it at On the double.
We mention the idea of averaging down because we recently came across this Bronte Capital blog, whose first paragraph was always likely to grab our attention, here on The Value Perspective. “The last post explained why I think a full valuation is not a necessary part of the investment process,” it began. “A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.”
Moving onto the question of averaging down, the blog notes this “has been the destroyer of many a value investor. Indeed averaging down is the iconic way in which value investors destroy themselves (and their clients). After all, if you loved something at $40 and you were wrong, you might love it more at $25 and be almost as likely to be wrong – and like it more still at $12 and equally be wrong.”
The Bronte Capital blog then expands its thoughts on the pros and cons of averaging down, which you can read more of at the above link. Here on The Value Perspective, however, we cannot help wondering whether the blog’s apparent scepticism on the subject might not have something to do with its initial assertion that valuation can be dealt with in a paragraph. Or even a sentence.
When thinking about averaging down, it is crucial to have a view – and, to be fair, the blog acknowledges this when it says: “Valuation might normally be a set of questions along the lines of ‘what do I need to believe’ to get/not get my money back.” In degrading the importance of valuation in the process of investing, however, we believe the author misses the point.
As Howard Marks explains in one of The Value Perspective’s favourite value books, The Most Important Thing: “For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.” So, yes, you have to have a view but we would go much further still – you also have to have the numbers to back up your thesis and valuation is a key component of that.
So you have to size up the strength of the company’s balance sheet and thus build up a sense of why the share price is likely to be falling. Is it because there is now high uncertainty around the stock and yet low risk? If so, you may well be right to average down? Or is it the case that there is high uncertainty around the stock along with high risk – for example, the business has a weaker balance sheet or has increased its leverage (borrowing)?
Is there perhaps fraud in the company’s accounts of which you were not aware? Or is the company misallocating capital to an ill-judged acquisition that will change the business as it is as well as its long-term value? As value investors, we embrace a long-term view, look to incorporate all additional information into our thesis and then decide whether there has been a negative material change.
If there has been, then averaging down is likely to be a mistake. As it happens, the Bronte Capital blog picks out Valeant Pharmaceutical, a business we touched on in Analysing accounts, as an example of “the iconic bad situation to average down” – “a [high borrowing] mergers & acquisitions business model involving fraud”.
So if it emerges there has been a deterioration in the business that justifies the lower valuation, it is not the time to average down. If, on the other hand, your analysis suggests there has been no real deterioration and nothing has changed apart from the wider market’s perception of the risk of the business, then averaging down can be a very powerful technique – as the following chart illustrates.
For illustrative purposes only and not a recommendation to buy or sell shares.
Source: Schroders, Thomson Reuters DataStream, FactSet, 1 January 2015 to 31 December 2016. Portfolio weight as at 31 December 2016. Past performance is not a guide to future performance and may not be repeated.
As we discussed in Principal focus, the wider market took a very dim view of Anglo-American in the second half of 2015 and the mining giant’s share price fell some 80%. Here on The Value Perspective, however, we were more confident in the business and averaged down on the shares all the way through their descent – and consequently enjoyed the benefit as they regained all their lost ground over the course of last year.
For, as Marks also advocates, once a value investor settles upon an intrinsic value for a stock, it is crucial they “hold it firmly and buy when it is available for less”. As we never tire of saying here on The Value Perspective, price relative to value and a proper assessment of your margin of safety are what count because, to squeeze in one final quote from Marks, “Investment success doesn’t come from buying good things, but rather from buying things well”.