When Should You Average Down?

When you find yourself constantly averaging down in a microcap it's normally a sign your ego has taken over and you've stopped being rational. You are making one of the deadly sins of investment. Being right has become more important than making money. You've forgotten that being broke and right is the same thing as being wrong.

John Hempton (H/T Luke who posted it on our community) wrote a good article on averaging down. In the article he writes about the types of situations that are poor choices for averaging down. 

Highly levered companies. I too have experienced this and why I tend to stay away from highly levered businesses. The issue with highly levered companies is the market cap and stock price can go down a lot but the enterprise value doesn't go down that much. It’s easy for equity holders to get wiped out figuratively and literally. Don't average down into highly levered companies.

Companies with obsolescence risk. These companies often look like they have a great "brand" but they have declining market share. I could give you tons of examples of this in microcap. A small $10-50 million market cap owns a brand most people remember and so you assume "it must be worth more than this". Most times it isn't. Or the company sells a "me-too" product or service with little differentiation. The company's goal is to put marketing lipstick on a pig and hope someone accidentally buys the product. Don't average down into pigs.

I would add two more situations to Hempton's list: 

Unprofitable businesses. A microcap investors biggest risk is dilution. If a company has less than 12-months of cash, 98.36% [sarcasm] of the time an equity raise is coming. Don't jump in front of the freight train. The stock market is really good at sniffing out a dilutive equity raise. When the stock market knows an equity raise is probable, the stock will be stuck in quicksand. In addition, after a company raises capital, it oftentimes takes months, quarters, even years to churn through the dilution and negative taste left in investor's mouths. Don’t average down into unprofitable businesses. 

Underperforming businesses. One of my biggest mistakes has been averaging down after a company posts a mediocre or bad quarter. 90% of the time another mediocre quarter is coming right behind it. We all want to believe the bad quarter was a one-time event, "this time is different", but it rarely is. Most microcaps are turnaround stories in some way. We love to root for the underdogs. We all want to believe things will get better – that the proverbial frog will turn into a prince. It's easy to convince yourself to average down one more time. Then you do it again and again. The frog was a frog. No offense to frogs. Don't average down into losers. 

I was recently interviewed by Morningstar India and I was asked about averaging down into losers and this was my answer: 

“If you personally lent someone money, and they only repaid you half of what they owed you, would you give that person more money? Of course not. Yet we continually do this with our investing, where we average down into things that have a history of disappointing us.”

Averaging down can be a wonderful thing. In fact, variable pricing is the best thing about the public markets. Short-term stock prices are yanked like a dog on a leash by the madness of the crowd.

Investor sentiment is a pendulum that swings back and forth between extreme optimism and extreme pessimism and never sits still. It's on the extremes where the astute investor waits patiently buying or selling.

Even Berkshire Hathaway, one of the largest, most durable businesses in the world trades in a 30-50% trading range every year. Every. Year.

Coincidentally this is also why many successful short-term traders focus on trading the same 2-3 stocks every year. There is enough volatility in a couple things to make a living. These successful traders find the pulse of a company's stock. They know when the heartbeat becomes irregular.

Microcap stocks are inherently more volatile which means you will have even more chances to average down.

In the Art of Catching Falling Knives I wrote about how at least once per year I’ll wake up to a position trading down 30% premarket. Some large holder wakes up grumpy and decides today will be the day to sell their entire position in an illiquid stock as quickly as possible.

It always feels like you’ll never get another shot to buy a company you love, but almost every year the market gives you another opportunity.

This leads us to the most important question - When should you average down?

The answer is to invert the list of situations to avoid. You should only average down when: 

1. The business is accelerating.
2. The business is profitable with no financing risk. 
3. The business has a sustainable growth trajectory. 
4. The business doesn’t have a lot of debt. 

Don’t average down into losers. Average down into winners.

If a stock is dropping and the underlying business doesn’t have all four characteristics above, let the stock drop. Let the position become a smaller portion of your portfolio. Don't catch the knife.

We all have losses in the portfolio. It's part of game. Don't turn a loss into a mistake. Mistakes are when our actions or inaction turns a small loss into a bigger loss. It's when you are hurting your returns.

Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.

The most gut wrenching and emotional times are when stocks fall. Remember the four characteristics you need to justify averaging down. Bookmark this article. It will help you when you need it.

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