Re: When do you average down?

A reply to John Hempton’s post on when to average down

The question

A few months ago, John Hempton asked the question “When do you average down?”

This is an important question, because as Hempton lays out, averaging down can represent either

  1. A source of additional returns (when you get it right), or
  2. A threat to your bankroll (when you get it wrong, especially if you get it wrong across correlated positions at the same time)

Hempton’s answer

Before getting into the details of Hempton’s answer, it’s important to think about the way he approaches the problem.

I’d characterize the way he approaches the problem as follows: he’s interested in classifying situations (into good or bad for averaging down) based on the characteristics of the business in question.

Specifically he comments on three specific business characteristics (all of which he suggests make for bad situations to double down), which are laid out below:

  1. Highly levered business models
  2. Operationally levered business models
  3. Businesses facing technical obsolescence

Let’s first consider #1, highly levered business models. Is Hempton right that Buffett is “very good” at not averaging down on highly levered business models? I don’t think so. Consider the following situations in which Buffett has doubled down on highly levered businesses — you could argue that some of Buffett’s most iconic investments consist of averaging down:

a. Wells Fargo, being a bank, fits squarely into the highly-levered category. Buffett significantly increased his position in WFC in 1990 — see his 1990 letter. Per his letter, Wells Fargo at the time was 20x levered, and the banking industry was in crisis. In terms of whether Buffett was averaging down, it seems likely he was averaging down, since he said in the letter that he bought 1/6th of his position in 1989 and the rest in 1990, and this is the historical chart:

 

b. American Express in the 1960’s (i.e. at the time of the salad oil scandal) was not a bank but was highly levered. You can see from their 1964 Annual Report (from this nice blog post) that they had assets that were 13x their equity. Now I don’t know whether Buffett averaged down when building his huge position in American Express, but given the concern hanging over the stock at the time, he probably did.

c. I don’t know if mid-1970’s GEICO counts as highly-levered, but it was levered (because of the leverage from its premiums) and distressed when Buffett went deep into it. Also, I don’t have this stock chart either, but I think again it’s likely Buffett was averaging down here when he built this big position.

As the above examples suggest, it seems inaccurate to say that Buffett has avoided averaging down on highly levered companies. In fact, Buffett has done it many times, including with some of his biggest and most iconic successes.

Another way to think about the problem

I propose another way to think about the problem of when to average down: what if instead of thinking about characteristics of the businesses at hand, we instead tried to make the average down decision based on indirect information about the investment?

Now what do I mean by indirect information? By indirect information, I mean characteristics about our knowledge and others’s knowledge about the investment, regardless of what kind of business is in question. I’d say put this in contrast to direct information, which would include the aspects Hempton originally mentioned (high leverage, operational leverage, risk of technical obsolescence) as well as other information about the company itself (such as management, operational excellence, growth rates, etc.).

The first type of indirect information to consider is how well you know the investment situation, i.e. where is this situation in relation to your circle of competence?

For instance, Buffett’s investment in GEICO was about as far inside one’s circle of competence as you can get: he’d been following the company for 20+ years; he was himself already experienced in the insurance industry, having acquired National Indemnity in 1967; he was a large enough shareholder to have deep insight into the company.

I think one principle of averaging down is that I probably shouldn’t do it unless I am very much inside my circle of competence. And even this is a necessary but not sufficient condition — in some ways, you can almost know a situation too well and become unable to clearly see its risks.

The second type of indirect information is to consider what the (reasonable) bear case for the stock is. There’s no precise definition of “reasonable,” but for me it would include cases from short sellers I respect (e.g. Hempton, Marc Cohodes, Gotham Research, Prescience Point, etc.), but would not include all short sellers.

People sometimes suggest that for any investment situation, the bear case is similarly reasonable — I don’t think that’s true. For instance, as Hempton points out, when Buffett averaged down in Coke in the 1980’s, there was really no bear case suggesting it was a zero, or anything close to a zero.

Again, this is not a silver bullet. I think of it more this way — situations where there is no reasonable “zero” type of bear case are more amenable to averaging down. But even if there is a “zero” type of bear case, that doesn’t mean it is wrong to average down, necessarily. To me, it just means you better be extra sure that you’re right.

The third type of information is the likelihood, in the case that you end up being wrong, that you will recognize that you’re wrong in time to be able to exit the position without a material loss.

To be more specific, it’s bad if situations are likely to end quickly and / or in binary ways — think financials (Bear Stearns, Lehman, etc.), entities with potentially-game-over regulatory risk (payday lenders, etc.). On the other hand, it’s good if the downside of a situation is likely to play out slowly with only incremental recognition by the market — think Hempton’s reference to Coke’s risk exposure to changing taste preferences.

I’d also say that I wouldn’t average down in situations where emotionally I’m more at risk of not seeing things clearly.

The fourth type of indirect information is how your original thesis has held up to the point when you’re considering averaging down.

I think it is especially dangerous to average down if you were originally wrong with your thesis — often people rationalize this by saying that their original assumptions were too aggressive, but given the decline in price their new worse assumptions now make for an attractive investment. If you do this, you are at risk of averaging down into a big loss.

On the other hand, I would prefer to average down in situations where my thesis is still correct, and to do nothing or exit the position in situations where my thesis is incorrect, even if it appears that the stock price has declined more than the thesis has suffered.

 

Summary

In summary, I’d prefer to think more about indirect information when considering when to average down. Specifically, I’d consider

  • How well do I know the situation and its risks?
  • What do reasonable bears think the downside is? I.e. if I’m wrong, what’s the magnitude of the likely loss?
  • Is this a situation where both (1) I can trust myself to recognize when I’m wrong, and (2) where if I’m wrong I’ll likely have the opportunity to sell without taking a significant loss?
  • Has my original thesis held up, or has it proven to be incorrect?

Disclaimer

The above is only the author’s opinion and is not investment advice.

2 thoughts on “Re: When do you average down?”

  1. Ultimately I would describe my criteria for whether to average down into two key ideas:
    1. Do I think my analysis is right despite evidence to the contrary?
    2. Does averaging down cause me to take a bigger total position in this stake than I feel comfortable risking/losing in a single position?

    The first is the most important question to ask from an investment perspective, and the second is a portfolio management question and depends greatly on your own personal risk tolerances and/or those of any investors or stakeholders.

    I commend Hempton for laying out his philosophy so his investors can rely on it, and now that he’s committed to that philosophy, he must hold himself accountable to that standard. I might not choose to use his same standard, however his investors may have demanded guidelines on how he could manage their money, or he may have wanted to impose such a guideline to limit his risks.

    I think that Hempton’s guidelines are better than average, if only because they marginally improve your odds of not multiplying by 0. Avoiding leveraged situations is the primary criteria Hempton points out, however leverage is inextricably linked to many investments and opportunity costs. LBOs, stock buybacks, debt issuances, and increased investor focus on returns on equity have resulted in increasingly leveraged situations.

    The value of leverage has always been magnifying the underlying returns, and the degree to which leverage impacts returns is considerable. If a company is highly levered and does well, the owners of the equity should do well (ceteris paribus), however doing well naturally pushes the company towards reducing leverage, unless the results are accompanied by proportional growth.

    One of the best points of this post is that managers should be actively seeking out the bear case for their investments. For example, I do not fault Ackman for his original call on Valeant, yet his additional purchases (including the purchase of calls and sale of puts) in the fall of 2015 after Citron’s report on Philador is good example of a situation where Ackman was within his circle of competence, but needed to pay more attention to the bear case. It is still easy to be over-confident in one’s judgment so long as are within your circle of competence. Unfortunately, one of the biggest risks when a stock’s price is declining can be fraud, which is extremely difficult to identify especially when concealed by a dishonest management.

    Ackman could have saved hundreds of millions for his investors if he had realized that he did not know the company as well as he thought (or even considered that might be a possibility), or that there could be underlying fraud despite his trust in Valeant’s managers. The fact that I know he read and reviewed Citron’s report makes his decision to double down willful blindness.

    Regarding leverage, the leverage underlying the security affects both the risks and returns possible, with more leverage in a situation making the investment more likely to pay off nicely if it “works” and more likely to run into trouble if it doesn’t “work”. Almost every asset has a price where I would consider buying it. Assuming I choose to buy a security at some price, it is based on the expected future of the underlying asset and my ability to receive cash payments in return for holding it or selling it for a higher future price. Leverage, especially high leverage, can create opportunities where the equity is an option on the underlying business, and the company must not only be successful, but successful enough to operate with the leveraged structure.

    The downside of leverage is it often compels companies to make decisions with poor timing–selling shares at market lows, and doing buybacks at market highs, the former usually being more costly to shareholders.

    It’s often difficult to re-analyze a situation when situations change, and that can create many opportunities. Distressed debt is an excellent example–many owners of debt at par do not have interest in owning distressed securities and can become uneconomic sellers when a company gets into trouble. The buyers of that debt are usually interested in distressed situations and not buying new issues at par, and are better at analyzing the situation and making a return. The difficulty in averaging down is being able to correctly analyze both situations and realize if and when things have changed.

    Many leveraged situations have been Buffett’s best investments, as his averaging down in levered stocks (and primarily being right) have resulted in fantastic returns. Being right was more important than avoiding leverage, in fact, leverage significantly magnified Buffett’s returns. Buffett more than most has laid out his investment philosophy in more than a half century of letters, though to my knowledge he did not limit his ability to average down in any significant way.

    Indeed, in the early years at Berkshire and moreso during Buffett’s partnership days, he was willing to concentrate heavily when he thought he was right. I am personally a big believer in concentration, as I believe that stock picking and stock analysis becomes considerably diluted when expanded to 20 or more positions. Averaging down should still be weighed against the risk of permanent capital loss, and the rules of thumb mentioned in this post and by Hempton can be useful (my favorite was seeking out the bear case). So long as you are right, artificially limiting your investment opportunities by portfolio management rules only constrains your results. It may be useful to do so in order to limit risk (see: Sequoia and Valeant), and to keep investors happy, but ultimately investors will be happiest with the best possible investment results.

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