This is our third article in a series of articles we decided to write in hopes of educating the average person on important investment concepts that are not normally discussed in the mainstream investment media. We wanted to provide the average person with a set of tools from which he/she can ask more informed questions to investment professionals managing their money. This article will focus on one of the most common mistakes both professional and amateur investors make when evaluating their investment research process. In particular, this article was influenced by a family friend of our firm. His questions and answers helped us to solidify the importance of this concept. So, if you love this article, thank him, and if you hate it, then blame our writing.
When investors turn their money over to investment professionals there is an inherent disconnect into the access of information. The majority of money management firms have slick websites and brochures touting their investment process or investment philosophy. But it is often difficult for the outside investor to be able to truly measure whether or not the investor is doing his/her job as advertised. As a result of this information disparity, investors use investment performance as the primary method of gauging their investment manager's competence. But there are important ways investors can become active participants in how their money is managed.
Many investment managers will discuss the use of average cost of stock when discussing the stock's performance. Not all investment managements will mention the cost of the stock when they first started buying it or the highest price paid. We believe that investors should be more concerned with the initial purchases, and understand how the use of average cost in marketing material is potentially very misleading. Investors who question their managers on the initial purchase price will be able to judge a manager's openness for honesty as well as the success of their investment process.
In fact, we would encourage all readers to ask their advisors to articulate all the purchases they made for a security on their behalf. Then they can compare this list to the list of sales to determine if the manager is making money from his/her investment ideas or by opportunistically trading their account.
Average cost is a simple concept. It simply represents the average price the investor paid for a stock. To calculate this number, you simply take the total dollar value spent on purchasing the shares, and divide that number by the total number of shares purchased.
So how is this misleading? Well let's say we purchase 5 shares of ABC company for $40.00 a share for a total cost of $200.00. Then let's say ABC is an oil company and during the recent downturn the price of the stock went to $20.00. So we purchased an additional 5 shares for a total cost of $100.00. Then because we are opportunistic investors we bought 10 more shares of the ABC company when the price hit $5.00 for a total cost of $50.00. This means we own 20 shares of ABC company for a total cost of $350.00 and our average cost per share would be $17.50.
Many professional investors discuss with clients about how they love when the price of a stock drops because they can buy more of the stock. This is fundamentally true. So our scenario above might be exactly what they want to happen. Or not. We have no problems with investors who purchase more stock as the price goes down. But the issue with the average costs happens when using the average cost to disguise bad investment decisions.
So let's continue our story from above. Let's say that with the rebound in the price of oil, our ABC stock goes from $5.00 back to $20.00 per share. Our 20 shares of ABC stock are now worth $400.00 and the investor is able to claim that he made a 14.28% return on our $350.00-dollar investment. And this is true. No question. But does this tell you anything about the quality of the investment decisions being made? Our opinion is that it does not. And if anything it can be deceiving.
Remember that when we first purchased the stock, we paid $40.00 per share. That means if we sold the stock for $20.00 now that the price has rebounded, then we are taking a loss on the shares we initially purchased. We would be taking a 50% loss on this purchase. The $200 dollars we spent that day represented over 57% of the capital we ended up investing. And what is happening is that the purchase of stock at $5.00 is driving all of our investment returns. But does this mean the investor is smart? Or is he/she lucky? We argue they are in fact lucky and thus their investment process is potentially not sustainable.
On the day the investor purchased the stock at $40.00 per share, the investor has no clue on which direction the market will go or where the price of our stock will go. We would say that is impossible for the investor to have predicted that he/she would have been able to purchase the stock for $5.00 in the near distant future. And in fact if they would have been able to predict this, then they would have not purchased the stock at $40 or $20, and would have waited to purchase the stock at $5.00.
So the investor should not get credit from a research perspective for this investment idea. They can get credit from a trading perspective. When they purchased the stock at $40, we assume they had an investment theory as to the value of the stock being significantly higher than $40. Let's say $60 dollars was the value of ABC company per share. And if they sold at $20 then they are saying that their investment value was wrong at that time despite the fact that they made money on this investment. So their research process led to an investment in a company and their valuation justified this investment, but they are selling the stock substantially below what they originally paid and below their value calculation.
Whenever a fund manager writes about average cost, you want to check to make sure that they made you money when they initially began purchasing the stock. And if they didn't then you need to find out why. This offers a great way to assess the skill and honesty of a manager. Ask them what the valuation was on the day they made the initial purchase. Then ask them why they are selling the stock below that valuation. And then ask them if they were able to predict the price would have declined below their initial purchase price. Finally, you want to ask them if they ascribe this transaction to their skills as research investors, skills as traders or luck. If they say skill, then you need to find out why they think that.
Sadly, this type of fool's logic happens all the time in the investment world. Just as we mentioned in one of the other articles that investors will want credit for the increase in the price of oil, but disown ownership in the decision-making when the price of oil collapses, investors seek to benefit from an investment process that caused losses.
When analyzing the investment decisions made at Dylan Street Capital, we compare our selling price to the initial purchase price and to the highest price paid for the shares, and not on the average cost of the share price. By focusing on the initial price, we can objectively try to evaluate whether or not our investment process is leading to attractive investment opportunities. We will use average cost only when we are evaluating our trading ability and our ability to reinvest capital during times of market volatility. But average cost is not used to evaluate our research endeavors.
We recently had this happen, and that was the motivation for writing this article. This investment is still active and we are choosing to not disclose its name yet. We first purchased the stock on Oct. 15, 2015, and it represented a 5% position in our portfolio. If we were like many investors we would write here that we intended to purchase more of the stock if the price fell, but since readers can't prove our intent on that day we think it is irrelevant. So we continue the story. During December, we purchased more shares of the company. The lowest price we paid represented a 24% discount to our initial purchase price. And because of all our purchases we were able to lower our average cost of the stock to 10.5% below the price we initially paid. In fact, had we been expert traders we could have purchased more shares at prices significantly below the lowest price we paid. After all these transactions this investment represented a 16% position in our portfolio at cost. Because the price of the stock has rebounded significantly we show a 35% gain on our average cost. But only a 20% gain on the initial purchase.
We provide the chart above to show you the returns we are generating from the four different purchases. When we bought the stock on 10/15/2015, we liked the valuation, but we had no idea that the markets and the stock would decrease significantly. So had the markets gone up, we might not have had the opportunity to buy more stock and thus, the returns we are generating from purchases after 10/15 are unreliable.
It happens in this case that both returns are attractive, but often investors will buy more stock to lower the average cost to cover bad investment decisions. Investors of all stripes are prone to buy more of stocks whose price is declining than those whose price is increasing. And unfortunately many investors use this lower average cost to spin their investment research process.
So, we will now address how this issue can be used to evaluate the research process of managers by using another example from Sears (NYSE: SHLD) and Fairholme Fund. Sears first appears in the Fairholme 13-F dated 11/14/2005. This 13-F covers purchases made after 6/30/2005 and before/on 9/30/2005. Using Yahoo Finance, we can pull the share price of Sears stock during that time period. You can choose to use which ever price methodology you will like but we look at the closing prices. The highest closing price was $163, the lowest closing price $115, and the average closing price was $141. (Note the average is just the average closing price, and not a volume-weighted average) It is important to note that these are the stated closing prices, and not the adjusted closing prices factoring in splits and spinoffs.
In the Fairholme call with investors, Bruce Berkowitz says they received $32 per share in distributions. So if we subtract $32 from the prices above, then we would get the adjusted price he paid for the shares. It would look like this: $131 (high), $83 ((low)), and $109 (average). If you read our other article, then you know we mentioned he valued the shares today at $147.00. We took issue with this valuation.
But we also noted that he said it was more likely that the price of the stock would rise and the intrinsic value would decrease such that they would converge in the middle at a price of $82.00. Thus assuming he bought the shares at their lowest price possible during his initial purchases he would only be making $1.00 a share after holding the shares for over 10 years. If he had purchased the S&P 500 at the highest closing price in the same time period, his return would be 64% gross. Note we aren't even including dividends received in this calculation. From a research process, this investment has failed. We also believe it demonstrates a form of anchoring, thus explaining why the $147 valuation only decreased $3.00 from $150.00 when he last announced the value of Sears shares.
To be 100% clear, we aren't saying that average cost isn't important. Averaging down can be a great way to make money for your clients, but as outside investors attempting to evaluate the investment process, average cost is less important. Berkowitz has purchased and sold Sears shares throughout the time he owned the stock. So his true average cost is probably much lower than the $82 we are using. But as we mentioned above it is impossible on the day of initial purchase to predict what would happen to the price of the shares, so we don't believe the investment process should get credit for that decline. And when an investor as such as Bruce Berkowitz advertises his firm as long-term value investors and not traders, then we believe our approach above is a great way to judge the success of an investment process.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.