Grasping Reality on TypePad, by Brad DeLong

...If you liked it at $10 you should love it at $6... "just buy more".... But... averaging down is the iconic way in which value investors destroy themselves (and their clients).... If you loved something at $40 and you were wrong, you might love it more at $25 and you almost as likely to be wrong, and like it more still at $12 and could equally be wrong. And before you know it you have doubled down three times, turning a 7 percent position into a 18 percent loss.... If you do not believe me this has a name: Bill Miller. Bill Miller assembled a startling record beating the S&P ever year for fifteen straight years and then blew it up.... How not to behave is be a false value investor, buying stocks on which you are wrong, and recklessly and repeatedly averaging down.

At the other end traders who (correctly) think that people who average down die. The most famous exposition of this is a photo of Paul Tudor Jones - with a piece of paper glued to his wall stating that "losers average losers". And yet Warren Buffett and a few of his acolytes have averaged down many times and successfully.... At least sometimes--the Bill Miller slogan is correct: "lowest average cost wins". Paul Tudor Jones may be a great trader--but he is not a patch on Warren Buffett....

When I look at tasks that can be achieved by a four-analyst shop I have one very high on my list of things we can do and should do: We should get the average down decision right more often. So I have thought about this a lot. (The implementation leaves a little to be desired.) At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.... The question becomes... not "are you wrong?"... [but] "under what circumstances are you wrong" and "how would you tell"? When you put it that way it becomes obvious that you must not average down (much) on highly levered business models. And looking at Buffett he is very good at that. He bought half a billion dollars worth of Irish Banks as they collapsed. They went approximately to zero. But he did not double down. He liked them down 90 percent, he did not like them more down 95 percent....

By contrast you can probably safely average down on Coca Cola: indeed Buffett did. It is really hard to work out a realistic circumstance in which Coca Cola is a zero. And if it is still growing there is going to be a price at which you are right--so averaging down is going to go some way to obtaining an average cost near or below that price. Of course even Coca Cola is not entirely safe....

There is another iconic way that value investors lose money--and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999.... Technical obsolescence is always a way you should be wrong. When the threat is obsolescence you are not allowed to average down. Bill Miller averaged Kodak down. Ugh.... Clear ex-ante descriptions of the issue (which require competent business analysis) might help with that problem....

The iconic bad situation to average down is a levered business model involving fraud. It is surprisingly common because people who run highly levered business models have very strong incentives to lie or to cover it up when things turn to custard. I can think of two recent examples: Valeant and Sun Edison. Much to my shame I added to my (small) position in Sun Edison as it fell.... When Bill Ackman rang Michael Pearson and asked if there was any fraud at Valeant he already had the wrong mindset. Then he added to a large holding in a company with over 30 billion dollars in junk-rated debt. Losers average losers. Incidentally, our six month rule (before you were allowed to add) would have saved Mr Ackman a lot of extra losses. Time has revealed plenty about Valeant. And it would have saved me at Sun Edison too...