I guess the question above would be particularly applicable to value investors, as they often know and understand their own companies best over a period of time and thus are often faced with the question of whether to purchase more shares in these same companies. An investor would be confronted with the simple question of whether he should average up (i.e. purchase shares at a higher price compared to his original purchase) or average down (purchasing at a lower price than his original purchase in order to reduce his overall average cost per share). Let’s analyze both situations to see what insights can be gleaned as to the actions to be taken, and also the ramifications and consequences of each action.
I guess this would be viewed as a simple decision – to purchase more shares in a company in order to reduce the cost of your holdings. Note that this can usually only be done in a major correction or in a protracted bear market, as the value investor would have usually purchased his shares with a requisite margin of safety to begin with. This means that it will be unlikely and improbable (but not impossible) for the share price to fall below his purchase price and remain there for a long enough period for him to accumulate comfortably. Even if this does happen, the investor must not only be nimble enough to be able to capture the opportunity to buy more shares in his favourite company, but must also control his emotions of fear and panic when market valuations plunge. The logic of buying more when prices fall may be sound, but in reality it can be difficult and uncomfortable to go against the crowd as human nature dictates that we feel more at ease following the direction of the herd. Hence, a seemingly simple action such as averaging down comes with a lot of emotional hang-ups, and as an investor who has done this before, I can only say that one must have both conviction and fortitude. In short, one must do the necessary research and be convinced in one’s own analysis to be able to carry out the transaction; and along with it also comes the ability to withstand short-term market price swings without batting an eyelid.
Another danger of averaging down comes in the form of the Value Trap. As one reader recently commented on my post on divestment of GRP, the one big mistake which all value investors face is the seemingly attractive low PER and valuations offered by a company which hides the true extent of its unsuitability. An investor must carefully assess the future prospects of the business, and convince himself that the business is able to at least sustain its cash flow generation to be able to pay out steady dividends, or that it is growing slowly but steadily. There is a fine line to be drawn between a company in a declining industry which is floundering, and one which is in a mature industry with little growth potential; but the difference can be of paramount importance in determining the returns to be obtained over the long-term.
It all boils down to an investor performing a conscious evaluation of a business’ potential to continue to generate profits and cash, in order to justify his averaging down strategy. A business is not always more attractive just because it has lower valuations, and vice versa; as everyone knows that conditions in the business world are never so simple. Hence, it involves a detailed assessment of valuations in relation to profit and FCF-generation capability. I am the first to admit that this is far from easy, therefore the decision to average down should not be taken lightly and should be a matter of grave importance – significant judgement is required to ensure that one’s investment does not spiral down into the depths of a black hole or chasm.
Averaging up, I feel, is a lot trickier than averaging down. Perhaps a reader might attribute it to a matter of perception, as it never seems to make sense to purchase something at a higher price (and by extended definition higher valuations) compared to one’s original purchase price. At this juncture, perhaps, I should clarify a few mis-conceptions about the process of averaging up which even I was prone to make prior to writing about this topic. These mis-conceptions do not just include those of valuation, but also involve psychological biases under the umbrella of behavioural finance.
When one thinks of averaging up, one immediately thinks of violating the basic principle of investing, which is to purchase at a more affordable valuation as compared to a higher valuation as provided by Mr. Market. But things are not always as simple as they seem – a business is dynamic in nature and is always changing, therefore valuations and prospects do not stay constant either. The difficulty is in determining what constitutes a margin of safety in purchasing at a higher price as the business may have improved or deteriorated since your previous purchase. The hard work involved is to assess and ascertain once again if the business is worth purchasing in its current form, by incorporating all new information, news flow and corporate actions and events since your last purchase.
To give a recent example of mine, I had averaged up on purchase of Boustead after an absence of 2.5 years. Essentially, I had to make another assessment of the Company based on the recent corporate newsflow, as well as reading the Annual Report FY 2011 thoroughly and by talking to and questioning the Management during the recent AGM in July 2011. This evaluation has to be conducted to ensure that at the current price level and valuation, Boustead would still make a decent and compelling investment. Once the assessment was done and the conclusion was made, I then proceeded to execute my order to accumulate more at a market price of 85 Singapore cents, and this was blogged about some time back in late-August 2011.
The behavioural bias involved in averaging up is anchoring bias, which means that one tends to use their historical purchase price as a mental “anchor”, and anything which is higher in PRICE tends to look more expensive in relation to your purchase price. However, this is a wrong attitude to have as your previous purchase price is considered history and should not be relevant to your current decision. In fact, one should behave as if one is considered the stock for purchase without owning any in the first place, as it is irrelevant to one’s purchase decision to always mentally anchor oneself to a historical purchase price.
From the above, it can be deduced that whether one decides to average down or up, the common theme in both cases is to do a rational and objective assessment of the business to see if it continues to be investment-worthy. It is never an easy and clear-cut decision and one has to be prepared for losses in case things do not pan out as planned; but we should take such lessons stoically and continue to learn from them. As investors it is impossible to avoid mistakes, but we should always aim to make small financial mistakes and to reap big financial rewards, which in the long-run would translate into an increase in financial assets and would bring one ever closer to the dream of financial independence.