How many times have great value investors affirmed the wisdom – and profitability – of this simple advice: average down when buying and average up when selling. How few – even those who understand its inherent logic – fail to do so on a consistent basis. It takes enormous discipline to not take a valuation cue from price action. Yet this is precisely what the great ones do not do – they take their cue from a dispassionate, margin-of-safety-infused estimate of intrinsic value. Without this practice, the Mr. Market parable is of little use, reduced to a quaint anecdote of Buffett’s mentor, Ben Graham.
Gurufocus has a nice feature where you can see both graphically and in tabular form the historic equity purchases of prominent value investors. How often have I observed that the best, focused value investors frequently buy more – sometimes much more – when a newly established position craters down in price. Conversely, I have frequently seen the same investors average up by selling a portion of their shares if Mr. Market makes a particularly tantalizing offer. This can result in a staggering IRR on the sold portion and greatly reduce the risk of capital loss on the remaining shares as they are held for greater gains.
In his recently published 2012 letter to Fairfax Financial shareholders, Prem Watsa – a preeminent practitioner of value investing who has grown book value by over 23% per year over 25 years and generated a 14% annual return on common stock purchases over the past 15 years – recounts how Fairfax Financial generated a realized gain of $341 million from International Coal using precisely this technique. (Prem lays it all out in tabular form). After initiating a position at $4.58 per share, they averaged down, bringing their average cost down to $3.37 per share. They subsequently sold half their position for a gain of 115% at $7.26 per share. The remaining shares were sold only five months later when there was a takeover offer for the company at double that price. (Fairfax sold at $14.60 per share.)
This was done without buying at the low or having any special ability to see into the future. All that was required was the right intellectual framework and emotional discipline. Watsa relates how he has been using exactly the same investing technique for the past 35 years.
Incorporate the same approach into your investing process and you will greatly increase your odds of beating the market.