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Whenever some financial "pundit" says that the best way to get into a stock is by averaging down, I cringe. Why? Because at best you'll be getting into a stock at a lower average price (which can also be accomplished to the very same effect when the stock is rising but more on that later) but more importantly, you can be getting into a stock that's poised to sink much, much lower-and that's a risk no one wants to take.

What is "averaging down"?

The concept of "averaging down" is straightforward. Say you buy a hundred shares of a stock at $100. It goes down to $90 and you buy more a hundred more. Your average cost per share has now been lowered to $95. Repeating this action as the stock falls will lower your average cost per share even more. Sounds good, right?

Investing or trading?

It depends. If you're investing in the stock-that is, you're viewing this as a trade and not a long-term investment-then averaging down is a strategy that runs counter to your goal of making a profit. Traders use buy and sell indicators to determine when to enter and exit positions. Should a stock fall enough to trigger a stop-loss, they exit the position and take a small loss at the most. Stock traders either don't care or don't know enough about the company's fundamentals to determine whether or not the drop in price is due to a temporary lack of buyers or whether it's reflecting a more serious problem that they don't know about or hasn't yet surfaced.

The situation may be different, though, if you're investing in the company itself. If, after doing your homework, you are convinced that the company is a good value and you are planning on holding the stock for a long time, then averaging down may work to your advantage. The operative word here is "may."

Even if you're convinced that management is on the right track and the fundamentals are solid, I still have a bias against this approach for a couple of good reasons. One is the fact that hype and circumstances can blind even the most judicious, rational investor. Previous Federal Reserve Chairman Alan Greenspan dubbed this condition "irrational exuberance."

Remember the dot-com bubble in 2000 when Internet stocks were bid up to frighteningly high valuations? How many of them are in business now? Go.com and Pets.com were two Internet darlings that quickly flamed out once the bubble burst.

Or what about accounting scandals that were kept so hush-hush that even top Wall Street analysts were fooled? Think Enron, Tyco, and WorldCom-companies that wiped out many a retirement account.

If you can't rely on market hype or trust fundamentals, then what recourse do you have other than using your mattress as a retirement plan? The answer is to follow the technicals because, unlike people, numbers don't lie.

A case study: It seemed like the perfect candidate

Let's take a look at a recent example of a market darling that has been experiencing a fall from grace. Last year this company was on everyone's buy list-Wall Street loved it, Main Street loved it. This is one of those "buy the dips" stocks making it a perfect candidate for the averaging down strategy.

What is the company? It's Deckers Outdoor (DECK), the maker of outdoor footwear and apparel. Their top brands include Teva and recently acquired Sanuk, but it's the Ugg brand of sheepskin footwear that makes up at least 80% of their sales and for which they are most known.

Brand popularity raises the stock

Deckers' stock suffered along with the rest of market during the 2007-2009 sub-prime crisis. In March of 2009 the market turned around. The S&P 500 staged a two year rally that ended in early May of 2011 when it hit a multi-year high. During that time, the S&P made a spectacular 100% return but as nice as that was it was chump change compared to the 650% return made by Deckers during the same period.

Clearly, investors and consumers were in love with the Ugg brand.

In the months that followed, the market began to slip as debt problems from the eurozone surfaced. Deckers, however, was marching to a different drum beat. It couldn't help but fall a bit in August of 2011 when the crisis was at its darkest, but it picked itself right back up. Late that October, the company reported earnings which blew out Wall Street estimates. The next day, the stock jumped over 10% and went on to post an all-time high of $118, tacking another 22% onto its previous gain.

Investors were euphoric.

The stock begins to lose its luster

But the bloom began to fade when the stock quickly reversed course in what would be the start of a major slide. Buying volume dried up reflecting a shift in institutional attitude. Because of the slack in buying pressure, the stock began to fall in tandem with the overall market.

On December 15th, an analyst at Sterne Agee downgraded the company citing slowing sales due to milder weather and rising material costs (mainly sheepskin). The price target on the stock was slashed from $130 to $72. The news triggered a 10% drop in the stock, breaking a major support level at $95 along the way. Many institutions and investors viewed this event as a shift in perception and began exiting their positions. Trading volume on that day was three times normal.

Was this a time to buy the stock? At $87 per share, it must have seemed like a bargain to those who were still enspelled by the Ugg mystique. Even CNBC's Mad Money maniac, Jim Cramer, named Deckers as one of his top holiday picks on December 27th. But some investors clearly didn't share his views.

Just two days later, the stock dropped another 8% on heavy volume. There was no news to account for the sell-off, but my guess is that investors and portfolio managers smelled a dog and were looking to shore up their books before the end of the year.

Another nail in the coffin

For the next couple of months the stock languished in a narrow trading range between $80 and $90 until its next earnings report on February 23rd of this year. Although the company beat again on earnings, it guided fiscal year 2012 earnings well below consensus. The reasons that management gave echoed the Stern Agee analyst's concerns: increasing material costs coupled with unseasonably warm weather. There is another possibility, however, that management would never stake claim to and that is this: Could the consumer's passion for the Ugg brand be waning?

A company issuing downward guidance is not the news investors care to hear and they responded by pulling out en masse. The stock tanked, losing yet another $10 per share along with 10% of its value, closing under the $80 support level for the second time.

It proceeded to fall from there. The downward trend came to a halt in mid-April when, with just a little more than a week before its next earnings release, the stock rallied back to $70 resistance on the anticipation of better news. To die-hard investors, hope springs eternal.

Unfortunately, their hopes were dashed when the company missed estimates-something it hasn't done in six years. The next day the stock opened down over 18% in yet another mass exodus. You have to hand it to that Stern Agee analyst-he was right on direction but a wee bit off on price target. Not only was his $72 price target violated, the stock broke support at $60. And it's been sliding ever since.

The cost of averaging down

There are many ways to construct an averaging down scenario on this stock but let's just say that you've been following the company for months or even years since the 2009 market low. In October of 2011, you witnessed the earnings blowout and were finally convinced that the company was "the real deal" and decided to buy the stock "on the dips."

The first dip following the earnings release occurred when the stock broke support at $110 on November 9th. If you had gone on to accumulate the stock using the "buy the dip" mentality, you would have bought at the events listed on Chart #1. These events include the break in support, the aforementioned analyst downgrade, and the subsequent disappointing earnings reports.

Chart #1


(Click to enlarge)

If you would have stuck with the averaging down philosophy by buying on the dips (using an equal share strategy and not including commissions or fees), your cost basis would now be near $81, as determined from the following table:

Averaging Down

Date Price
11/09/11 $106.39
12/15/11 $86.46
02/24/12 $77.72
04/27/12 $51.83
Average Cost $80.60

(Closing prices are used unless otherwise noted.)

At the time of this writing, Deckers stock is at $44. That's a 45% discount from the average price of $81. If that statistic doesn't bum you out, this one will: You'll need an 84% move to the upside just to get back to your break-even point!

Seriously, is that what you want or would you rather try a different approach?

The opposite approach: Averaging up

Instead of the "buying the dips" mentality, how about buying the pops? That is, buy when the stock gaps up either due to a compelling technical reason such as breaking through a key resistance level or due to a compelling fundamental reason such beating earnings estimates, raising earnings and/or revenue guidance, making key acquisitions, etc.

Let's use this "averaging up" approach with our candidate company, Deckers, and see how it compares with the opposite strategy of averaging down.

The market is rising and so is the stock

Let's say it's early spring of 2009 and you've been making a list of stocks you'd like to buy once the market rallies. You find the Ugg brand appealing and are interested in possibly buying a piece of the company. You research the fundamentals and like what you find.

Next, you turn to the stock chart and see that it's beginning to rise along with the overall market. You patiently watch it, waiting for a catalyst to give you the buy signal. Finally, you get one in late October of 2009 when the company easily beats Wall Street's earnings estimates. The next day, the stock gaps up on heavy volume and you jump in.

You keep on doing the same thing-buying the pops-for the next several quarters as the company continues to thrive and beat estimates. Chart #2 below shows the dates of the last three trades that are included in the following table. (There wasn't room to show all four trades, but suffice it to say that the first one is very similar to the others.). Note the "pop" in the stock and the spike in volume following each earnings report.

Chart #2


(Click to enlarge)

If you had bought on each of these earnings "pops," your stock position would look like this:

Averaging Up

Date Price
10/23/09 $32.36
02/26/10 $40.03
04/23/10 $52.35
10/29/10 $58.10
Average Cost $45.71

Sure, your average cost basis is more than your initial price of $32.36, but you still have the satisfaction of knowing that you're holding a position that's profitable down to your break-even point of $45. That's quite a sizable safety cushion! And isn't having a safety cushion a lot better than trying to play catch-up?

Deciding when the buying stops and the selling begins

You could keep on accumulating shares as the price rises, but a prudent investor (without a very long investment horizon) would begin selling his or her position at the sign that the company's fortune is reversing. The first technical indication that Deckers may be in trouble came on 11/9/11 when the stock broke its $110 support level. (This was the date of the first "buy the dips" purchase.)

The "official" tell, though, was the analyst downgrade on 12/15/11 mentioned earlier. You would have seen the stock gap through its $95 support level (see Chart #1) and either have chosen to sell some or all of your position. If you had sold all of it at the closing price of $86.46, you still would have made a profit of $40.75 a share-that's a gain of 90%! But even if you had steadfastly held onto your entire position throughout the stock's further decline, you'd just be at the break-even point right now (at the time of this writing). Isn't it comforting to know that you're even able to weather such a tough storm?

Summary

We've seen how averaging down can lead to disaster while the opposite approach, averaging up, can lead to higher profits at lower risk. I can hear your thinking: Why would someone buy a stock on the way down when the fundamentals are indicating a contraction in growth? Don't forget the power of irrational exuberance-even a seasoned Wall Street professional like Jim Cramer gave Deckers a two thumbs up following a 30% drop in stock price AND a major downgrade. Just remember that investor perception can take much longer to shift than the price of a stock.

So, if you're ever tempted to buy a stock on the way down, recall this "Ugg-ly" example and resist the urge. Don't let it happen to you!

Source: Why Averaging Down Is A Bad Investment Strategy