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.
But I would prefer a simple modification to this process. This is a modification we have not done well at Bronte (at least formally) and we should do better. And that is the question of averaging down.
--
Warren Buffett is famously fond of "averaging down". If you liked it at $10 you should love it at $6. If it goes down "just buy more". And in the value investing canon you will not find that much objection to that view.
But averaging down 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 you almost as likely to be wrong, and like it more still at $12 and could equally be wrong.
And before you know it you have doubled down three times, turning a 7 percent position into a 18 percent loss.
Do that on a few stocks and you can be down 50 percent. And in a bad market that 50 percent can be 80 percent.
And if you do not believe me this has a name: Bill Miller. Bill Miller assembled a startling record beating the S&P ever year for fifteen straight years and then blew it up.
Miller had a (false) reputation as one of the greatest value investors of all time: In reality he is one of the biggest stock market losers of all time and a model of how not to behave in markets.
How not to behave is be a false value investor, buying stocks on which you are wrong, and recklessly and repeatedly average down.
--
At the other end traders who (correctly) think that people who average down die. The most famous exposition of this is a photo of Paul Tudor Jones - with a piece of paper glued to his wall stating that "losers average losers".
And yet Warren Buffett and a few of his acolytes have averaged down many times and successfully. And frankly sometimes I have averaged down to great success.
At least sometimes - the Bill Miller slogan is correct: "lowest average cost wins". Paul Tudor Jones may be a great trader - but he is not a patch on Warren Buffett.
--
I would love it if I had an encyclopaedic knowledge of every mid-cap in Europe and could buy the odd startlingly good business when tiny and cheap. But the task is too large. The world is complicated and I can't cover everything.
But when I look at tasks that can be achieved by a four-analyst shop I have one very high on my list of things we can do and should do: We should get the average down decision right more often.
So I have thought about this a lot. (The implementation leaves a little to be desired.)
--
At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.
At the first pick the question then is "when are you wrong?", but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.
So the question becomes is not "are you wrong". That is not going to add anything analytically.
Instead the question is "under what circumstances are you wrong" and "how would you tell"?
--
When you put it that way it becomes obvious that you must not average down (much) on highly levered business models. And looking at Buffett he is very good at that. He bought half a billion dollars worth of Irish Banks as they collapsed. They went approximately to zero. But he did not double down. He liked them down 90 percent, he did not like them more down 95 percent.
By contrast these are the stocks that Bill Miller blew up on: American International Group, Wachovia, Washington Mutual, Freddie Mac, Countrywide Financial and Citigroup. They were all levered business models.
By contrast you can probably safely average down on Coca Cola: indeed Buffett did. It is really hard to work out a realistic circumstance in which Coca Cola is a zero. And if it is still growing there is going to be a price at which you are right - so averaging down is going to go some way to obtaining an average cost near or below that price.
Of course even Coca Cola is not entirely safe. You could imagine a world where the underlying problem was litigation - where some secret ingredient is found to be a carcinogen and where the company faces an uncertain future of lawsuits. It is not likely - and if it happens you are going to get at least some warning that this is a circumstance on which you could be wrong. Whatever, outside that circumstance on which you might be warned, Coca Cola is not a leveraged business model subject to bankruptcy and is almost entirely unlikely to halve four times in a row. You can average that one down.
Operationally levered business models
Not every business model is as as safe as Coca Cola. Indeed almost every business model is more dangerous than Coca Cola. A not financially levered mining stock can halve five or six times. If you have a mining company that mines coal at $40 per tonne, has no debt and the price is $60 a tonne it is going to be really profitable. But prices below $40 (highly possible) will take profits negative. Add in some environmental clean up and some closing costs and it is entirely possible that a stock loses 95 percent of its value. Averaging down when down 40%, some more when it halves, and then halves again and it will still lose two thirds of its value. The difference between averaging stuff like that down and doing what Bill Miller did is only one of degree.
It is still a disaster. And you will have proven Paul Tudor Jones adage: losers average losers.
Obsolescence
There is another iconic way that value investors lose money - and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999.
You might thing it was worth owning Kodak as a "cigar butt stock" - plenty of cash flow and deal with the future later. There was a reasonable buy case for Kodak the whole way down. But technical obsolescence is always a way you should be wrong. When the threat is obsolescence you are not allowed to average down.
Bill Miller averaged Kodak down. Ugh.
---
If I could improve our formal stock notes in any way I would like an ex-ante description of what circumstances we are allowed to average down a particular stock, and how much.
We have a default at Bronte - and the default at Bronte is that we have a maximum percentage for a stock (typically say 9 percent but often as low as 3 percent depending on how we assess the risk of the stock) and as the fund manager I am allowed to spend that whenever I want but I am not allowed to overspend it. If we have a 6 percent position with a 9 percent loss limit and it halves I am allowed to add three percentage points more to the exposure. But that is it. Simon, being the risk manager, isn't particularly fussed if add the extra when the stock is down 30 percent of 50 percent, but I can't add it twice. If it is a position on which we agree we are allowed to risk 9 percent then I am allowed to risk 9 percent.
We will not fall for the value investor trap of losing 18 percent on a 7 percent position.
We have made a modification of this over time. And that is every six to nine months I get another percentage point to add. That is at Simon's discretion - but the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more.
But we can and should do better with ex-ante descriptions under the circumstances in which we are prepared to add and circumstances where we are not. The problem is that you can wind up in a mindset where you always where you want to add, where you think the world is against you and you are right and you will just be proven to be right.
Clear ex-ante descriptions of the issue (which require competent business analysis) might help with that problem.
--
The bad case of averaging down
The iconic bad situation to average down is a levered business model involving fraud. It is surprisingly common because people who run highly levered business models have very strong incentives to lie or to cover it up when things turn to custard. I can think of two recent examples: Valeant and Sun Edison.
Much to my shame I added to my (small) position in Sun Edison as it fell. Ugh. But also this was a highly levered business model and thus by definition the sort of place where losers average losers. I should not have done it - and I won't in future.
But the highly levered business models apply fairly generally. When Bill Ackman rang Michael Pearson and asked if there was any fraud at Valeant he already had the wrong mindset. Then he added to a large holding in a company with over 30 billion dollars in junk-rated debt. Losers average losers.
Incidentally our six month rule (before you were allowed to add) would have saved Mr Ackman a lot of extra losses. Time has revealed plenty about Valeant. And it would have saved me at Sun Edison too.
--
Whilst I think that someone asking me (as per the last blog post) for a valuation on every stock is absurd, I think it is entirely reasonable for them to ask "under what circumstances would you average down". If you can't answer that you probably should not own the stock. I should insist on it with every long investment.
John
41 comments:
Great post. one thought: much of the power of dividend reinvestment comes from the periods where you're mechanically averaging down. Of course, the types of equities that this works with are few. The proverbial cokes.
Great post. I really appreciate this kind of meta-thinking about value investing, and it's the kind of thing we all need to spend more time on.
As someone who has made plenty of these mistakes myself, I'm looking for rules to help prevent the worst mishaps. I think one good one would be to make a presentation or pitch to friends whose opinions I respect. The feedback I'm looking for in this case wouldn't be whether or not I was right about the investment, but rather they thought I had the right process and frame of mind going in to the discussion.
My numbers include dividends.
As I was reading this post, this headline : COCA-COLA SUED FOR ALLEGEDLY MISLEADING CUSTOMERS ABOUT SUGAR popped up on Bloomberg.....
I thought this was a great post, I like your risk management based rules.
I often think in circumstances like this a price based rule is helpful. If a stock drops from 100 to say 50, why not wait for a partial recovery before averaging down? A recovery say to 70 could well be the indicator that you're not wrong and there'd still be plenty of upside?
Thanks for sharing your thoughts on this John.
What about a highly levered business model with a strong underlying NAV or liquidation value in excess of current levels (E.g. GGP bankruptcy)? Would be interested in your thoughts as I feel that would be a fundamentally different scenario than just any other highly levered business model, and I would want to avoid any rules that preclude an ability to act in such a situation.
Averaging down is fine if you are truly an investor in the business (like Buffett always is) as long as the original case for buying remains intact, but most people average down because they don't want to take or show a short term loss. Since Buffett won't invest in a business he doesn't understand or one in which he can't understand the financial statements (Enron), Its unlikely that any of his investments would ever go to zero and I doubt if he would ever add to position more than once. You wouldn't blow out your fund with any one investment even if it did go to zero as long as you limited the $ investment to a maximum portion of your capital.
Adding to losers or "Cannonballing' as it was called in the Chicago pits greatly increases your winning percentage while simultaneously guaranteeing disaster in the long-term. Sounds like Miller averaged a lot of losers over the years (with other peoples' money of course) which always works spectacularly well until it doesn't. In other words if you pockets are deep enough you look like a hero for a long time until your fund explodes.
The sugar point with Coca Cola has already been made, but it is real. Paying researchers to falsely malign fat and to promote sugar as healthy is potentially an asbestos-scale existentuial crisis. Creating a generation or two of diabetes sufferers is a lot of damages ...
The funny thing is, your rules for averaging down look shockingly similar to prudent rules for initiating a position in the first place.
Thanks for taking the time to write.
I agree with your starting point, i.e., 15 pages on the business, and will shamelessly plagiarize and adopt your thinking on leveraged businesses :) Personally, I'm explicit about the investment thesis, i.e., what has to go right for us to make money, where is our POV non-consensus and what metrics will we look to confirm or disprove. In the event of a decline, part of the check is then if anything material to our investment thesis has changed. Helps take the emotion out having this documented a priori
Thank you John. Been reading your posts and as a young analyst you helped me around investing more than my PM.
Wow. An excellent article. Thumbs-up.
Nice article, I tend to buy into falling markets and when it goes wrong it goes very wrong, I think if you have a good grasp on the fundamental value of a company you should be trading as if long gamma, ie buying on the way down and selling on the way up, the way to survive by doing this is diversification ie I would tend to run 50-100 names so even your 3% holding would be an outsized position, A concentrated portfolio cannot afford to double down the already large position but a well spread one can. Also the value traps tend to leave less of a mark !
Fantastic post.
I got burned with SunEdison last year. Would love to see a detailed post from you on SunEdison. What went wrong, etc.
I still haven't been able to figure out why SUNE ended the way it did.
Interesting post but I couldn't disagree more with the first few lines. Probably explains why your fund struggled badly in a brilliant fundamental VALUE market in 2016.
John - how do you think about "averaging down" on shorts that have gone against you?
Great post. Another approach could be as taken by this guy: http://smartbeta.co/quant-value-portfolio/
John
I am trying to compile a list of investment mistakes of value investors and learn what not to do. Your post put a few things on my list. You do a great service to the value investing community through your blog. I appreciate it.
Vishal
One of the crucial things about a good business and is part of the "averaging down" process is the invest company's ability to allocate capital between new plant, acquisitions, debt retirement, equity retirement and fee up capital from surplus assets, non-core areas etc. Without harping about Thorndike's "Outsiders", it's very clear these decisions can have a massive impact - over time - on valuation. I'm gobsmacked that you relegate valuation to such modest relevance. I totally accept the comments about technological obsolescence but even that can provide a buying opportunity if investors ascribe too aggressive a fade rate - which you would only figure out from valuation analysis. BTW, I don't use DCF's to any extent, or if I do, impute out-of-market discount rates to ascertain what sort of bargain I'm getting. Without being a smart-arse, to what extent do you think your lack of emphasis on valuation has restricted your returns over the past 12-18months when there were some very clear "value" bargains available globally - stocks trading at way below intrinsic value (or value to a competitor) with modest to low business risk?
Fantastic post, John!
As a value investor, we are almost always early, this is something I always have to think long and hard about. Btw, a quick check on revenue trends also gives clues about obsolescence and is good to look for in cases with a lot of operating leverage.
Melting ice cubes are things I have learned to avoid. Too little reward for the work!
Averaging down is a sign of overconfidence.
A very simple solution for the value investor: start with the cheapest quintile of stocks (however you choose to measure value). Within that quintile, only own the stocks that have had the best performance over the past 12 months.
Nick de Peyster
Undervalued Stocks
Great post. but one that is way too harsh on Bill Miller imo. He made some mistakes in 2008, to be sure, but calling him one of the biggest stock market losers of all time is more than a stretch.
He did average down financials in the GFC but he also realised he was wrong in sept 08 ish and turned around and sold. he didnt average down to zero. he also eventually took his losses and cut his kodak position to zero. despite these losses he still beat the s&P during that period - thats hardly blowing up the fund.
post gfc he has also reprised is record of continuing to trounce the market, and his long term returns including 2008 are still well ahead of the market.
he made a handful of very costly errors in 2008 - which i would imagine and hope he has now corrected for - but overall miller has demonstrated clear investing aptitude over time.
miller reminds me of keynes' admonition that it is better for reputation to fail conventionally than succeed unconventionally.
LT
John - how do you think about "averaging down" on shorts that went against you?
One point on the obsolescence issue: I think this is a case where principal/agent issues are particularly rife, and though it would be foolish to double down as an investor, it could be smart to average in as an owner.
If you are an investor, and by definition a minority holder in the company, then something like Kodak is likely to be a loser. Management does not want to lose their jobs, nor do the multitude of workers they feel responsible for in the legacy businesses, and so every dollar of that tantalizing cash flow you buy the company for is likely to be spent in the pursuit of some new liferaft business that will keep everyone employed.
If, instead, you can be an owner, then it's a different story. You can stop trying to invest in areas away from the core business, plan to continue cutting costs and capacity to match the demand for the legacy business, and effectively manage the company down to liquidation while maximizing cash flow. This will cost a lot of jobs, but they are likely jobs that would disappear just a few years later anyway after a lot of uneconomic investment. This seems to be one of the unique niches where private equity is a valuable contributor, by pulling cash from less economic investments and pushing it to investors for reallocation.
Shorter version: Cigar butts are only worth buying if you can take the last puffs yourself and throw it away once you're done. But it does come with a (probably unavoidable in the longer run) human cost.
Worth noting that this is still a difficult endeavor, as you need to accurately assess the remaining lifespan and size of the legacy business revenues. And it's a wrenching process to manage, since you're up close and personal with forcing employees into a painful transition. Even Warren Buffett failed in the case of Berkshire Hathaway, which after all started out as precisely this sort of control play for a declining legacy business.
Thanks John, very informative. It could be applied to Forex , maybe not the bolivar but the pound ?
Really a great posting!
Thanks a lot, very good ideas for a tricky problem: If, when and how much to add on fallen stocks. Sometimes it is a way to get rich, sometimes a way to get ruined.
Until now I had one rule: If a share has fallen around 30% it is time to revaluate the share: Either I sell the share or I add some shares.
You opened a third option: Do nothing, if I still think the company is good, but the company is highly levered.
John, your ideas and explanations are education and enjoyable. Much appreciated, thanks for sharing.
Although not a simple averaging down in the "on market" trade sense, equity raising / rights issues put me in the same quandary (ORG and STO being recent examples). Of course each business and situation is unique, however the commitment to a "non market" valuation that will later be converted to the market valuation makes me view equity raisings (perhaps irrationally) more negatively than buying on a market price reduction.
Perspectives of you or your readers would be much appreciated
Thanks for some useful thoughts. Successful investing ain't easy. If you have a strict rule to never average down, you simply become a momentum investor. Maybe that works for some folks, but it doesn't fit my comfort zone. I'm a value investor, and by objectively looking at my own performance over the years, I've found that I'm ALWAYS early (some would say wrong). So I'm always going to average down, unless I can discipline myself to do better. But having rules as you suggest to enforce that discipline certainly helps. I've also adapted to my tendency to be early by only buying a 1/3 to 1/4 position to start, with the thought that I will buy again as the price gets better (lower). That's helped. But there have been some cases where the stock has gotten away from me before I could acquire a full position. Your advise about a levered business model is spot on. I've fallen for some value traps, but now I pay more attention to balance sheets and cash flows. But even with some blow-ups, I think that when you follow the adage "to buy when there's blood in the streets, even if it's your own," can yield some huge returns. At times like the last crisis (2008), who knows where the bottom is. At some point you just have to jump in. A momentum guy might wait for the market to rally 20% before buying. But if I'm early by only 10% (that is, the market goes down 10% more after I buy), I'm still ahead 10% relative to the momentum guy. But if it goes down another 30%, then I'm worse off by 10%. By buying partial positions each time, I think I improve my odds of ending up happy.
Your best thoughts in a while
I know from the pain. Been a sucker - leveraged business decent position after averaging down. And to the DCF models, my models were great and that is why I felt confident to average down. Two investments in 2011 went bad for me. One I averaged down and it got worse and one I did not. It is easier to take pain if you are not averaging down.
Now I am so scared of even thinking of averaging down. I know that is wrong too. But unless I am really convinced about I don't think I am trying it out. Even if models suggest so.
Rahul
Averaging down a single stock is very different from averaging down a diversified index. Just a thought.
Hello, great topic.
From my point of view, on top of that there is an issue when you average down, committing more capital to your investment = more financial expenses. I do not average down, I sale at a loss and I enter into the market once I feel confortable.
Many highly levered banks did come back but many did not ... if you are caught in a market meltdown even good stocks go down. The debate now is are the pharma roll ups like Valeant, endo etc coming back? They have huge debt but also good cash flow.
First up buy cheap in the first place and you're less likely to need to average down, i never double down in one hit, wait till the price has fallen at least 20% and buy 50% of the dollar value of you're entry, repeat after another 20%, now wait...works 80% of the time for me.
Warren Buffett once said of his early investment career that he went off in diligent search of deep, deep values and unfortunately, he found some.
Years later, I myself went down the same path, and the two rules I found that are of huge utility in avoiding value traps are: (1) using estimate revisions and earnings surprise as a tool for measuring how far off the rails the investment thesis has run, and (2) keeping a close eye on financial leverage - unleveraged businesses that aren't hemorrhaging cash have the luxury of time, while highly leveraged businesses may not survive even only a couple of bad quarters of financial distress.
From a qualitative perspective, it's always useful to ask yourself with as much intellectual honesty as you can muster: is my original investment thesis at all intact, or is it not? Importantly, many/most/all really good investors are unusually vulnerable to commitment bias, because they're even more likely than most humans to resist admitting that they're just flat out wrong.
Nice article that makes good points.
Of course Miller was uber talented but it is hard not to wonder how many times he doubled down into positions that were far too large and luckily got out, before he went off the rails in 2008.
Not sure how you compare Buffet and Tudor-Jones....their investment styles couldn't be any more opposite. Short term futures vs buy-and-hold forever (to an extent).
given the different natures of stocks and etfs, i wonder whether the same rules for averaging down would apply to an etf, say SPY or an inverse SPY, or a leveraged etf?
GREAT POST.
Capital Markets
Free-float Market Capitalization
as an often frustrated public markets investor, i come back to this post often. it's amazing.
Very important read in these times. "The iconic bad situation to average down is a levered business model involving fraud." $CVNA?
Post a Comment