Readers often ask me if they should average down on X, Y, or Z stock—or if that would be throwing good money after bad. Here’s how I see it…
First, the basics:
- Price and value are not the same things.
- Investors are emotional, fueling market momentum that often creates substantial divergences between price and value—both to overvalued and undervalued extremes. These are opportunities to go long or short.
- When the value proposition in a speculation has not changed for the worse, but its price has fallen, averaging down can be a great opportunity to leverage a position to the upside.
In short, when my favorite chocolate goes on sale, I don’t conclude that there must be something wrong with chocolate; I buy more.
I have big wins in my portfolio now that would not be as great if I had not averaged down (particularly among uranium stocks).
The big challenge, of course, is being sure that the value proposition has not deteriorated—or hasn’t fallen as much as the price. The latter distinction is important for resource speculators because commodity prices fluctuate a great deal. That means that for us, the question of whether to average down comes at times when prices for the mineral underlying the company we own stock in are down. So, we have to ask ourselves if the stock is oversold compared to the mineral as well as whether we expect the mineral price to recover.
My friend Rick Rule tells a story about one of his most famous successes: Paladin Energy in the uranium bull market of 20 years ago. I don’t remember the precise numbers, but he invested at something like 10 cents, averaged down at some lower price, and then had a moment of real soul-searching when the stock went under a penny. Being highly confident that uranium prices would rise, and seeing nothing wrong with the company, he averaged down again. The stock then went to something like $10 in 2007.
That’s got to be the best outcome of serious averaging down I’ve ever heard of.
Obviously, it doesn’t always go that way. I’ve heard from readers who averaged down on a stock they liked, only to see it keep sliding and sliding until the company went under or got taken over for cash at some low price that locked in their losses.
That begs the key question: how can investors tell the difference between trying to catch a falling knife and bagging a real bargain?
There is, of course, no formula for always getting this right. No mere mortal can reliably predict share price outcomes.
There are, however, principles we can apply:
- When a stock is on sale for the “wrong” reason, it can be a great chance to increase our potential upside by averaging down. For example, when a company announces a private placement, share prices fall to the level of the placement, which is almost always lower. This can happen even if the price of the underlying mineral is rising, increasing the value proposition in the play. Other examples would be scary, but irrelevant headlines (like a coup or nationalization in a nearby country).
- If a stock is on sale for good reason, averaging down invites a greater loss of capital. Sometimes companies stumble—lose a key permit, find “nasty” mineral in their ore, fail to control costs, come up empty-handed in a high-profile exploration effort, etc.—and recover. This makes it tempting to hold on or average down on a losing position one really doesn’t want to take a loss on. But in my experience, this is almost always throwing good money after bad. It’s possible for a company to recover from a material setback—but it’s unlikely. And even when it does, it’s often after a share rollback that makes it almost impossible for shareholders to recover even if the company does. As speculators, we have to play the odds. And the odds are against betting on losers.
- It’s critical to distinguish between markets and companies. If, for instance, a copper stock is down because copper is down, the issue is with the market for copper, not the company, specifically. If all the data we see is bullish for copper, then averaging down at such a time could help us “buy low.” But if mineral prices are up and the stock is down, the issue is with the company. That could be an opportunity if, for example, some major institutional shareholder is facing redemptions and is forced to liquidate a large number of shares. It could be a grave danger, however, if the company has serious problems management is keeping quiet, and those in the know are selling. How to tell the difference? We can’t always, but that’s what due diligence is for.
- Don’t get emotionally wedded to stocks. When this happens, we can find ourselves averaging down even when there is material, company-specific bad news. I see this among people on social media a great deal. Some company suffers a major setback, and its supporters flood the internet to tell anyone who’ll listen how great a buying opportunity it is. It’s like children covering their ears, shouting, “I’m not listening! I’m not listening!” Buying on the basis of failure is almost never an opportunity (unless you’re going for a hostile takeover).
This last point may be the single most important takeaway. In my experience, bad decisions are less often about lack of data and more often the result of getting irrational about one’s dreams for a stock—and being too proud and stubborn to admit a mistake.
That’s my take,
P.S. If you want my help with your due diligence, note that we have unbiased evaluations of hundreds of resource stocks under coverage in My Take—and we add more every edition.
