Is Averaging Down the root of all Evil?

I am sure you will have seen me say this before, but sometimes I sort of get a minor dose of ‘Writers Block’. It’s not terminal or anything, so you will be able to get your masochistic kicks from my spiel for a while longer, but it’s sort of about Enthusiasm.

Don’t get me wrong, I am utterly enthusiastic for the WheelieDealer Experience, but sometimes I sort of struggle to get motivated to write a particular Blog. I have a list of Subjects you could stick on a Bog Roll in fine print and still have space to wipe your butt, but (Ed. nice use of 2 butts or buts) it seems to often be the case that none of them salivates me on a particular day.

For instance, I know I need to do the Asset Allocation one and I have about 5 in an 85% finished state - but I just don’t fancy doing any of them. So, I have been struggling a bit to find a topic I really am keen to do today. However, as luck (or bad luck in this case) would have it, the Profit Warning from Boohoo (BOO) today (I started writing this last week !!) has fired up this subject area in the excitable bits of my grey matter.

Right, the link is this. I woke up this morning at my probably pretty much usual 8.30am after a pretty rough night’s sleep, and straight away saw the extremely unwelcome news that BOO had done a Profit Warning and the shares were down 40% ish - I really don’t need those kind of jolts into the land of the living - a cup of Tea would be much more to my tastes……

The drop seemed extreme to me. I know BOO was a fairly fully valued stock with High Expected Growth, but a 40% drop seemed nuts. So, I read and reread and reread again, the Trading Update and there was a fair amount of good stuff in it - and it was clear that the issue was over expectations that clearly were going to be missed to a large extent. But the Revenue Growth was still 25% and the Gross Margins were up a bit - most Companies on the Stockmarket would love to have such a problem !!

Unfortunately, because I was lying in bed, I did not have access to my Beloved ShareScope software which sits on my PC - this would have given me an EPS number prior to the Warning and I could then do a guesstimate as to a likely EPS going forwards. This would enable me to get a rough p/e valuation after the 40% drop.

I have to say I was quite amazed how I was unable to get any information on an Expected EPS number or even the EPS that was forecasted before today’s warning. How on earth do people know to buy at 22p if they have no idea of the valuation? I did a question on the advfn Bulletin Board and I asked around on Twitter - but no one came up with either number. Most weird. Normally I find that if I blast out a question, I usually get an answer in minutes to pretty much any kind of bonkers question I may throw out - Twitter is brilliant in this way and so are the people I interact with on it.

The Bulletin Board shocks me most. There are people on there saying “this is a buy opportunity, I topped up” and others saying “it's overvalued, sell, sell, sell” - how on earth do they know, if they can‘t even tell me an EPS figure? I am befuddled.

Anyway, as usual, I am rambling big time. Maybe that is why I wanted to write this blog. I am a bit pushed for time today as I didn’t sleep too well and got out of bed very late - so much of the day was wasted (disgusting behaviour). The great thing of this blog is that I am just bashing it out without having to do any research or cross referencing or anything - makes it shed loads quicker and easier.

I apologise if it is a bit too rambling even by my usual scattergun standards.

Averaging Down
Enough already, let’s cut to the chase. The reason BOO inspired this Blog is because I am now in a situation where I have decided to stick with BOO (yes, yes, I know it is a psychological flaw and I should move on and Stoploss etc.) and I expect any ‘Rehabilitation’ in the Share Price is going to be a long time coming. But I expect that at some point in the distant Future, I will be ‘Averaging Down’.

The Average Down is one of those Stock market ‘tricks’ that gets a terrible press. I see it everywhere - “Never Average Down”, “Averaging Down is idiotic”, “Only Dickbrains like Wheelie Average Down”……you must have seen similar.

And on the whole, I have to agree that Averaging Down CAN be a really, really Dumb idea. However, I don’t think that is always the case, and there comes a time and a place for the Downwards Average (I fancied a change on that one).

There are really 3 categories of the ‘Average Down’ that I wish to explore further below - firstly after a Series of Profit Warnings; secondly as a result of the usual Market Ebb and Flow, and finally with regard to Funds.

After a Profit Warning or 3
When I think back over a long and painful Investing Career, I realise that I have Averaged Down a lot of times and when I have done it carefully, it has worked out superbly and made me a lot of extra cash. It has now hit my brain that I need to do a bullet list of the Rules of Averaging Down:

• NEVER Average Down straight after a Profit Warning. The problem is that Warnings tend to come in multiples - rarely is there just the one. Usually you get three before the company actually gets on the mend - and quite often this coincides with new CEO and Chairman perhaps.
  
• Only Average Down when it is clear that the problems are behind the company and things really are on the mend. You need to be extremely careful - if you buy in and the company is still Broken, then you will compound your error and you will lose even more money than the pain you have already taken.
  
• I think Averaging Down is only safe and sensible on certain types of Stocks. Thankfully for me, I tend to buy pretty solid businesses and if they do have a Profit Warning, it is a temporary Event and they tend to recover - although it can take a couple of years, which means my Money is dead for a long period. But the fact is that after a Profit Warning or 2, Share Prices can get horrendously Oversold, so when things are on the mend, you can really get some Huge gains as the Profits improve and the p/e Multiple expands. It is also the case sometimes that beaten up Stocks following a Warning can become Takeover Targets.
  
• Certain stocks are just plain toxic. I would suggest that anything that is in the WheelieBin (please see the ‘WheelieBin’ page of my Website) or has the characteristics of a WheelieBin Stock as per my List, is just unsuitable for Averaging Down. You can only do it on proper, solid, Businesses that have just fallen on hard times. The biggest no no, is stocks with a Big Debt pile - Never Average Down on these as it will go wrong.
  
• Use the Charts and Technical Indicators to help you decide when it is Safe and a Good Time to Average Down. The obvious ones are Moving Averages - a Golden Cross on the 50 day and 200 day Moving Averages (this is where the 50 Day moves up and over the 200 day from below) would be a good indication that the Market thinks things are improving and Sentiment is back in favour of the Stock. The 200 day MA is worth watching - if it starts to Slope Upwards after a Downwards Slope and a bit of Sideways, the Market is probably telling you that things are getting better. But you must tie any Charting Signals in with the Fundamental Analysis of the current situation facing the Company. As I repeat over and over, I see Fundamentals and Technicals as complimentary approaches and used in combination they can be very helpful.
  

One other point to consider is about how well you ‘know’ a particular Stock or Company. Which is the better Stock to own? A Stock you have only just discovered and really know bug*er all about or a Stock that you have followed for years and years and it has just fallen on a tough patch? I think there is a good case to say that the Latter is a far better place for your money - but you must be very careful.

This is a Risk that the Stoploss Approach totally skims over - there is a huge risk that by using a 10% Stoploss or whatever, you are just getting out of great Long Term Investments that you know inside out and you run the Risk of buying into a New Stock that you really do not know anything like as well.

So, my view on Averaging Down after a Profit Warning or series of them, is that it can work out very well but you must be extremely careful. Averaging Down when you think a Company is fixed, only to find it isn’t, can be extremely expensive and hurt your Wealth bad.

Averaging Down on a Pullback
For myself, I am very much a Long Term Investor, so the Ups and Downs of the market can be opportunities to buy more stock at advantageous prices. Many ‘Traders’ will be chucking their Lunches up as they read this, but I see Investing and Trading as very different - and I know well that Warren Buffett would be topping up on Pullbacks. For more information on this distinction, please click ‘November 2014’ under the ‘Blog Archive’ and look for ‘Are you an Investor or a Trader?’ - on my Fone it appears on the Second Page of Blogs for that month.

Let’s clarify what I am saying here. In the normal course of events and in an ‘Ideal World’, I like to Buy a slug of Stock after a thorough dig into a Company and if it starts to move up nicely within a few days, and if the Candle Patterns and my usual Chart Indicators (MACD, RSI, MA, etc.) look favourable, then I will buy more Stock. In these cases, I am ‘Averaging UP’.

However, it is usually the case that a great stock moves in a very clear Uptrend Channel with a distinct Top and Bottom Trendline marking the Floor and the Roof of the Uptrend. So, in this case, if I buy a stock, thinking I have got it pretty good on the timing, but then I find it slips back and has got cheaper, if I am really keen on the stock, and I have ‘space’ within my Sizing Limits for the Stock to buy more, then I will be looking for a chance to Top-up.

It could be the case that my Initial Timing was pretty poor and the stock might fall 15%, but I am looking for clear Candle Signals and other Indicators to tell me that it is turning up again - then I will pounce and buy more Stock - so I might get more Stock at a 10% better price than when I first went in - so I am ‘Averaging DOWN’.

Of course, you have to be extremely careful and try to understand why the Stock has been falling - you need to be all over the News and Bulletin Boards and maybe asking other people on Twitter if they have any idea why the Stock is misbehaving. If you smell a Rat - you have a decision to make - did you get your initial Analysis wrong and should you now Sell and take a hit or are you still very confident that this is a good stock and the Market is just mispricing it? - often it does this in a General Market Pullback. If you have a bit of doubt, but you think it is OK, then maybe it is best to just stick with the Position Size you already have and not to Top-up. You will get plenty of chances in the future to buy more.

Averaging Down on Funds
Funds (Unit Trusts(UT), Investment Trusts (IT), Tracker Funds, ETFs) are quite unusual here and have a massive advantage in that they almost Never go bust. In fact, I cannot think of one Fund that has actually gone bust - although I do remember some Unit Trusts after the Dotcom Boom in the dying days of the 1990s that ended up being swallowed by other Unit Trusts - but they didn’t actually go bust. In the Credit Crunch some ‘synthetic’ ETFs got in trouble because their ‘Counterparty’ got into financial difficulties. See my ‘Funds’ page on WheelieDealer2 for more details on these different types of Funds.

Investment Trusts can have Gearing (borrowing, where they use borrowed money to boost their returns), and I suppose if you have a particular IT with a lot of Gearing then maybe it might go bust - so care would be needed here. But, maybe you should be asking yourself why you are buying an IT with a High Level of Gearing anyway? As an indication, I would suggest that any IT with borrowing in excess of maybe 30% of its Market Capitalisation, is probably to be avoided. I would be far happier with 10% to 15% borrowing as a Maximum. Equity investing is risky enough without adding the risk of lots of borrowing on top. Property ITs may be an exception to this and perhaps Higher Borrowing would be OK - it is up to the Reader to decide what level of Borrowing you are prepared to accept - and, if you get it wrong, you must learn the lesson.

Unit Trusts tend to have ‘Mandates’ that dictate that they cannot borrow money or they can only borrow, say, 10% for example.

In a way, this virtually total inability to go bust is a huge and largely ignored advantage of Funds. It is worth thinking about this if you are a Low Risk and nervous type of Investor - it might be worth checking out my ‘Funds’ webpage as well. Would you be better off just investing in Funds and not buying individual Company Shares?

So, because of this almost total inability to go bust, you can perhaps take more Averaging Down liberties with Funds than you can with normal Stocks. The simple approach is to Average Down and buy a load more of a Fund when there is a big Drop in the Markets - times like the Credit Crunch and these kind of Bear Markets are truly awesome times to be buying at advantageous prices. As ever, care must be taken and I would suggest that in a Bear Market, where Indexes are just falling mercilessly and in obvious Downtrends, you should wait it out until there are clear Chart signals that the Markets and Fund Prices are moving out of the Downtrends - and even then it is probably best to ‘nibble’ and just buy chunks of a Fund over time - maybe spread over several months or weeks.

I find one of the best times to buy is when you see the Main BBC News at 9pm and they have a Headline saying “Stockmarkets Collapse in Terror over Hungarian Sausage Crisis” (calm down, there is not a Banger Crisis, you don’t need to rush to the Deli Counter just yet) - that is a brilliant ‘Contrarian Indicator’ that markets are about to Rally big time. Mainstream Media is utterly hopeless at giving the Man on the Street financial advice.

Remember, it is at the point of Maximum Fear where Bear Markets turn up to become Bull Markets. Equally, it is at the point of Maximum Euphoria where Bull Markets break and become Grizzlies……..

Similarly to my Ebb and Flow comments earlier in this Blog, when Markets are generally Trending higher, you can take advantage of any weakness to top up on a Fund - this might be an Average Down.

Key Point
Anyway, the one thing to keep at the forefront of your mind when you are considering an Average Down is BE CAREFUL !!

If in doubt, don’t do it, stick with what you have or Sell out of the Stock.

Enough rambling,

wd