Wednesday, February 10, 2016

You need conviction to average down in a stock

"You pay a dear price for cheery consensus. "

Warren Buffett

I like to buy shares when prices go down. This ensures that my capital buys me more shares, and therefore buys me more dividend income. If prices go down further from the point at which I made my investment, I would be inclined to add to this position. As an investor in the accumulation stage, I want lower prices. If/When I get to be living off dividends, I will likely only care about the dividend checks I get deposited magically in my brokerage account. Stock price fluctuations would be irrelevant, unless I have extra money to invest.

The reason why I typically do not panic if the shares I own decrease in price is because I only focus my attention on solid blue chips which have the types of products and services which people use on an everyday basis. While earnings per share could temporarily go down during a recession, chances are that the earnings power of those enterprises will remain intact. If the fair value of a company is the sum of all the earnings from now until eternity, then it doesn’t really matter if in one of those years the business earns $2.30/share rather than the $2.50 it earned the year before, if I believe that earnings can rebound later. As long as that business is expected to continue operation as a going concern, I have no problem adding to my exposure.

The reason why I can say I will not panic but add to my position is because I study a lot of businesses, before choosing only the best for my money. This includes looking at items such as historical data on earnings, revenues, returns on investment, catalysts for future growth, technological obsolescence, competition, competitive advantages etc. If I like the business of a company like PepsiCo (PEP), Hershey (HSY) or Johnson & Johnson (JNJ), I will get really excited if it is available for sale. I will not be scared away from a temporary weakness. This willingness to buy stocks at a discount only works with quality companies whose earnings streams are relatively immune to the economic cycle. There is the risk of trying to catch a falling knife, which is mitigated by the stability of the underlying business and the cash dividends extracted to lower the amount of capital at risk.

The ability to buy a good company at a discount is also dependent on doing your own homework, rather than listening to someone else for stock tips and investment ideas. If you have done your own homework, and have decided in advance how you will react under different scenarios, you will have the conviction to act, but also the safety nets in place in case you are incorrect in your assessment. Unfortunately, we as investors sometimes do not do our own homework and spend too much time listening to everyone, rather than taking the time to do our own research. Without independent thinking and independent "system" to follow, successful investing of any type is difficult to accomplish.

That doesn’t mean that if I believe that there is the chance for a permanent deterioration in fundamentals that I will keep averaging down in that business. For example, while I last bought some ConocoPhillips (COP) in the early hours of 2015, I quickly changed my mind after a few weeks. I realized that lower energy prices should bring down my estimates for earnings and the ability to cover the dividend. As I mentioned before, there is a real risk with cyclical companies, since they appear cheaper at the top of the cycle and most expensive at the bottom of the cycle. This is because their earnings are highest right before things turn for the worse, but earnings are worst (or non-existent) when things are close to an upturn. The other danger with cyclical companies is that for some, the turn never arrives, because they over-leveraged themselves during the boom times. This is why averaging down doesn't work as well with cyclical companies, but could work better with quality companies whose earnings are not exposed as much to the economic cycle.

I am very patient in monitoring companies, and evaluating whether one-time items you see in annual data points are trends or fads. At the end of the day, a company that is successful will generate so much in extra cashflows, that it will be able to fund a growing dividend to shareholders. If things change, as things changed for newspapers like Gannett (GCI) or for retailers such as Winn-Dixie (WIN), then those are not the companies to add to. This is why monitoring the story is important.

Either way, if I like a business, and I believe that its ability to earn money is not impaired, and I believe that this business stands a high chance of operating and earning more in the next 20 years, then I will have the conviction to add to it when prices go down. Otherwise, I run the risk of trying to catch a falling knife, which could be dangerous for my future retirement based on dividend income.

Full Disclosure: Long HSY, PEP, JNJ,

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