The last post explained why I think a full valuation is not a necessary part of the investment process. A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.
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.
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.
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 ever 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.