Don’t Average Down, Average Up Instead

Investing processes are unique to each individual and investment firm. While some rely on investment checklists (I once built one with nearly 80 data points), others might rely on calculating the potential intrinsic value using a discounted cash flow (DCF) model and yet others might focus on the qualitative aspects of the business (management, industry, macro, etc.). Some investors might choose an event-driven strategy like merger arbitrage or stock spinoffs and others might only use technical analysis. I personally use a combination of idea generation from event-driven strategies, building a DCF model when required, peer comparison and writing about the business. Writing helps crystallize my thought process and makes me dive deeper into the qualitative aspects of the business than I would have otherwise.

Once a potential investment is identified through the investment process of your choice, you have to then figure out how it fits into the portfolio.

• Do you have to sell another position to make room for this new investment so it does not throw off your asset allocation?
• How do you size this position given its risk/reward characteristics and your standard position size?
• Do you already have exposure to other companies in the same industry?

After all this work is done in selecting an investment, it is not surprising that once you buy the company, objectivity sometimes flies out the window. We often get anchored to the price at which we bought the company. Instead of looking for dissenting opinions, we seek information that feeds our confirmation bias. When having coffee with my neighbor last week, we were talking about markets and I mentioned to him that markets do an excellent job of keeping us humble. Just when I think I have done the work and understand an investment, something goes wrong either on account of an external factor outside my control or through an error of omission on my part. The market humiliates the best of us frequently enough to keep this game interesting.

Whether it is Paul Tudor Jones putting up the sign “Losers Average Losers” on the wall behind his desk or Jesse Livermore warning us not to average down in Reminiscences of a Stock Operator by Edwin Lefèvre, this advice is hard for most investors to follow. We are conditioned to look for bargains in life and fall into the trap of, “if it was good at $30 per share, it is a screaming buy at $15”. Unfortunately a big drop in price doesn’t necessarily translate into the need to back up the truck, fill the boat or sell the farm to buy more. More often than not, it points to an error of omission in your analysis, changing industry conditions or a shift in market leadership/style (from growth to value for example).

Value investors and company insiders often get anchored to old prices based on my observations following insider buying for more than a decade. I am often reminded of Bill Miller averaging all the way down on housing stocks during the Great Recession of 2007-2009. Warren Buffett did not make the same mistake and did not average down, even as the Irish banks he invested in lost nearly 90% of their value.

Instead of averaging down, we should consider averaging up on investments that are working. It is remarkable, how consistent good businesses and management teams are, at executing and creating value for their shareholders. If you find a good business, it does not have to be a one and done deal. Investing by averaging up through a new purchase or by reinvesting dividends through a DRIP plan can work wonders. This strategy is similar to what venture capitalists are required to do as their portfolio companies perform well and raise more money through new investment rounds. Their investment process forces them to average up and concentrate their investments. I have shifted my investment process to average up instead of averaging down over the last few years and could not be more thankful with the results.

There are always exceptions to every rule and I wrote the following when discussing the online education company Coursera (COUR) in our May 2021 Special Situations newsletter,