7 pointers when Averaging Up on a stock

By Larissa Fernand |  22-09-21 | 
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About the Author
Larissa Fernand is an Investment Specialist. Follow her on Twitter @larissafernand

In My biggest investing goof-ups, I wrote about the 3M stock. It was one of the very first stocks I purchased. My biggest regret has been that I never added to that position as the years went by. Had I done so, I would have been a very happy (and a much richer) investor.

All along I bought into the narrative that the stock just does not justify its PE, despite having a good brand and decent pricing power. Coupled with sheer lethargy, I missed out tremendously.

I realised I was not alone. Dev Ashish informed me that he suffered the similar predicament with Asian Paints. “It does sound ridiculous in hindsight, but I never averaged up as much as I should have,” he says. In the aftermath of the 2008-09 Global Financial Crisis, right up to mid-2010, he loaded up on Asian Paints. Being a valuation conscious investor was proving to be his Achilles' heel. When he scrutinised the stock through a fundamental lens, it was a good buy. When he did it through the valuation lens, he faltered. The result was that though he had a good allocation to the stock, he never bought Asian Paints again on the way up.

Averaging up refers to the process of buying additional shares of a stock one already owns, but at a higher price. This raises the investor’s average price of acquisition.

Almost two decades ago, investor Bill Miller threw out a fascinating term in an interview with Barron’s.

He explained how he owned a substantial stake in Amazon and even in AOL since its infancy, so it was “embarrassing” that they missed eBay and only had a moderate position in it. He blamed it on valuation illusion. He elucidates by naming two historical valuation illusions: Walmart and Microsoft.

From the day they went public, they looked expensive. Had we known the growth that was ahead for both companies, we would have known it was actually a bargain.

If you bought Wal-Mart when it went public at an expensive-looking 20+ times earnings, you would have made returns of many 1000% on that.

The same goes for Microsoft. Until a couple of years ago, Microsoft went up an average 1% every week it was public, despite the fact that it looked expensive.

Most people were looking at eBay and focusing on whether they could keep growing at 40%, which is a legitimate question. We discovered, however, that although it looked expensive, it didn't have a lot of the risk associated with other companies. No balance-sheet risk (huge amount of cash and no debt). No technology risk (they are a user of technology and simply provide a platform). No visible competitive threat (nobody has anything approaching their business). No inventory risk (they don't take any inventory). No receivables risk (they don't hold receivables).

At a Manhattan conference in 2005, when he was asked why he liked the “very expensive Google”, he replied, “What’s not to like? Huge profit margins. Rapid growth. Management has executed brilliantly. And it sits in the nexus of where all of the long-term trends are going in media.”  He later mentioned in a 2006 shareholder letter, with reference to a high-multiple name such as Google, “as if multiples of earnings or book value were all that was involved in valuation. A 100% of the information about a company represents the past, 100% of the value depends on the future.”

Averaging Up is counterintuitive. But, extremely critical to an investor.

I recently came across some sophisticated jargon in one single sentence: Critical counterintuitive is one of the most compelling mental models in the world of investing.

  • Critical: Once you comprehend it, you will never underestimate its importance. Little else matters.
  • Counterintuitive: Because it goes against the buy low philosophy; it does not “feel right”. It is the opposite of what I believe.
  • Mental Model: I will use the explanation that author James Clear provides. A mental model is an explanation of how something works; the framework you carry around in your mind. The best mental models are the ideas with the most utility, that will help you make wiser choices and take better actions.

Averaging up fits the bill.

William O’Neil calls it the stock market’s great paradox: “what seems too high and risky to the majority usually goes higher and what seems low and cheap usually goes lower”.

As Sanjay Bakshi has often said: “If you've picked the right kind of business, which will be worth several times current market valuation in a few years' time, don’t hesitate in buying its shares simply because they are selling at an all-time high market valuation. Focus on the potential future value a decade or so from now and how much money is there to be made between now and then. Because when it comes to high-quality businesses, there will be multiple times to buy more shares.”

Please remember these lessons:

  • Averaging up will require you to move more money into stocks that are increasing in value. It appears counterintuitive, but in doing so, the winners get magnified.
  • A stock being “cheap” should not automatically excite you. It could be that the fundamental economics of the business has deteriorated. It could be that it is losing market share. Focus on the future return of capital, not the past return of capital.
  • To anchor your buying decision to the price you paid for the stock is a defeatist strategy. Your buy decisions must be anchored to information about the company and its business. The price of the stock should enter the picture only after you have analysed the company behind the stock.
  • The key to averaging up is because the company in question provides a more compelling value proposition (even at a higher price which might look optically uncomfortable to purchase) than the available alternatives. If not, then you got to redirect your capital.
  • You will always look for reasons as to why the stock price is falling. Do it when there has been a price acceleration too. Maybe the company has been reducing its debt as a percentage of equity over the past few years. Maybe the company has been gaining market share. Maybe the management has executed better than anticipated. Would you not like to increase your exposure to such a business?
  • This may surprise you, but the objective of investing is NOT to be right. There are other ways to satiate your ego. The objective of investing IS to make big money when you are right. And to lose the least amount possible when you are not.
  • Let me end with some advice from Dev Ashish. He attributes his comfort level to buying more shares at a higher price than what he originally paid by spacing out the purchases. He gradually builds up positions instead of buying in one go. “I take a reasonable position in the company I am interested in and from then on, I buy more in smaller lots as my conviction builds and the company continues to prove my thesis right. Averaging-up is now a side effect of the conviction build-up process for me,” he explains. A strategy worth implementing.

Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.

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ninan joseph
Sep 26 2021 12:33 PM
 My two cents to this.

No one in this world including Warren Buffet can ever judge how well a company is going to succeed. When a company comes out with their IPO even warren buffet can and would only invest a portion of his money in these company. The accumulation phase happens only after investing. Once you invest in a company and then you see on a quarterly basis, the company grow, you will start accumulating the stocks. Say at IPo you got the shares at 100, after 4 quarters the MV is 130 and you start accumulating, buy do remember your average even after accumulating will be lesser than the market price because the original lot was bought at 100. Again after 4 quarters the MV goes to 200, you then start accumulating, but at any point of time, after accumulating, the average cost will always be lower than the initial investment and stock will always be in the green. This is how wealth is made. Hence it is critical that when you buy a stock, you understand the business, are you buying the business or are you buying a stock. If you are buying the business, you will monitor the growth prospect of a company. If you find growth, you will accumulate, if on the other hand there is no growth, you start to redeem the stock.

It is imperative to believe in the company you have invested, you will monitor the growth and then invest in them again and again. This is the only way, you can have quantity and have wealth. What is the point of owning 25 shares of HUL which was bought at 550 per share. Saurabh Mukerjee says, even if you had invested in Asian Paints over the several years at its highest point your return would be handsome. Hence it is important to identify growth oriented stocks and then keep monitoring them. Once you have eneough quantity and the price if you think has gone high, sell a portion and reduce your average cost. Buy back the same stock when it dips. Every stock gives you this opportunity or a correction of a consolidation.
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