Averaging Down On Value Shares

Published in Investing Strategy on 3 June 2010

What does the Aviva experience say about value?

Time for a bit of navel gazing here. I'm not going to do the full value portfolio review because I did one last week. As I write though its value totals £64,488, up a little over 1% since then, despite my decision last week to go for crisis play BP (LSE: BP) which has fallen back about 15%.

Averaging down on Aviva

I want though to examine the situation with Aviva (LSE: AV) and its implications for averaging down value shares generally. I brought this one into the portfolio in a series of tranches which caused it eventually and deliberately to be highly overweight. To illustrate this, it represents 38% of the current portfolio's cost and 36% of its present value, though it is only one of ten shares.

I loaded up on Aviva because of my belief that it was ridiculously undervalued. And as the price fell after the first purchase, with no change to the fundies that I could see and therefore in my view due only to negative market sentiment, I bought more. But as we now know it subsequently went on to fall a lot further. 

The average buying price including costs is 378p so at 336p, it is down 11%. It was though down a fair bit more a few days ago when the W recession explanation-compulsion disorder (ECD) sufferers, a different class of course from their equally disturbed V or U observers, held sway for a while.

I've got no time for ECD. What may be interesting though is why people suffer from it. Does everything always happen for a reason? No.

What to do when a share price falls

Anyway, going from the particular of Aviva to the general, should a value player average down on a share that has fallen a lot since purchase? In my view yes, but with a couple of conditions.

Clearly one has to be satisfied that the fall is just noise and not fundamental deterioration. It's not always that easy to glean this information however. There's often a "no smoke without fire" feeling that if a share has fallen seriously, especially where this is much worse than the background market, then there may well be some fundamental reason for it which has yet to be made public but which has leaked out to those in the know.

The other point concerns portfolio construction. If you are running a value portfolio of several holdings where you normally split the investment cost equally between them, you could be uncomfortable with going too overweight any share because of the excessive risks involved. In that case you may be uneasy with averaging down, however appealing it may look. But I haven't applied that thinking to this portfolio.

You have to consider the smoke and fire possibility. But how to test for the risk of it being present? There's no simple answer. You start by reading the company's own recent press releases. But there is unlikely to be much guidance there because if there was then it would be public domain.

There's also online discussion boards but they don't necessarily tell you that much really because there is often too much conflicting opinion. Also a lot of it is frequently just hot air from people commenting from a background of little real experience of the market or the matter in hand. 

In the end, where you are open to the general idea of risking more money in averaging down a value play that has fallen a lot, it comes down to your own judgement call as to whether the share in question is genuinely even better value than when you first bought it.

The risk problem

Averaging down presents an interesting risk problem. 

It could turn out to be good money after bad or, as you would hope, prove to be even better money after good. 

The upside of doing this is twofold. First by lowering your overall purchase price, the share then needs to rise less than it did before to put you in the money. Second, because you have more cash invested in it, you will probably make much more money if it does the business. But the downside is that if it doesn't, then you'll lose even more.

My judgement with Aviva is that it was worth averaging down because the value increased on the lower price and I still believe this even though it has fallen further. 

Nothing is safe from market sentiment for a time though ultimately such views evaporate in favour of the hard facts. I haven't seen anything yet to change my mind on this share though that does not mean that there can't still be some nasty in there somewhere waiting to expose itself and cripple the investment. 

It's a risk but one I'm willing to take.

More from Stephen Bland:

> Stephen holds shares in BP and Aviva.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

timthegambler 03 Jun 2010 , 1:56pm

Surely averaging down just increases your risk and exposure to the company. I assume you have the assumption that Aviva must recover, and must stabilise to a point considerable above both your purchases (otherwise why put more money in). What if this is wrong? Diversification out of the window!

Anyway, my main point of this post was to gloat that I got Aviva at 296p.

They do seem unpopular though, don't they.

rober00 03 Jun 2010 , 4:55pm

My understanding is that professional managers neverhardly ever average down.

On this basis Stephen you are very probably right to do so!!!

lotontech 03 Jun 2010 , 8:18pm

I know that experienced traders try to never average down, but I don't know about 'professional managers'.

In any case I prefer to 'average up' by establishing an initial position size, and then adding more funds -- i.e. pyramiding -- when the price goes in the right direction. The trick is to add more funds only when the 'risk' of adding the additional funds is covered by the profit already accrued on the original funds.

I've linked to two articles on 'pyramiding' that I wrote for "Smart Investor" (no adverts) some time ago, because I know the moderators don't like me linking to my own blog or books. You should find these articles relevant to the 'average down' (or not) debate.

http://www.stockbrokers.barclays.co.uk/content/misc/landing186.htm

http://barclays-stockbrokers.co.uk/content/misc/landing72.htm





FunkyIndexFinger 03 Jun 2010 , 10:14pm

There is a game called gamblers ruin, in which you keep doubling your bet on a 50%/50% gamble until you win. Provided you have unlimited capital, you can never lose at this game. Nobody has unlimited capital, and so you eventually lose out on this type of game.

Averaging down is a form of this game. Of course, with more belief in your own research the odds are more in your favour. Ultimately though, if you always play this game, one day you will be averaging down on RBS or Bank of Scotland.

It is not a very good way of building a balanced portfolio. However, you can re-balance your portfolio when the price goes above the average (if you decide to reduce the risk).

The advantage of a balanced portfolio, is that it maximises your expected profit while minimising your volatility.

By averaging down, you are for a short period perhaps, increasing your volatility, but not necessarily increasing your expected profit.

Sidekicker101 04 Jun 2010 , 3:00pm

Based on TA, the target for Aviva is round about the 200 mark.

taikosan 07 Jun 2010 , 6:21pm

The behaviour of Aviva's shares seems to be completely illogical unless, as you say, there is bad news, known to some but, still coming to the rest of us. If that is the case, there will be a serious need for an investigation into insider dealing.
The only alternative is that it's the hedge funds, again, selling down to enable a takeover by 'Private Equity' and fill their pockets in the process. Nearly all the UK's best companies have already gone through this con trick.

maldonian 08 Jun 2010 , 9:19am

As a former institutional pension fund manager I can confirm that they do often average down their holdings,especially if the relative value looks compelling.However if this reults in the size of holding becoming too large,e.g. as a % of the whole portfolio,or relative to the sector weighting,then they usually have to limit further purchases,to avoid predetermined risk controls.

Drunsfleet 08 Jun 2010 , 12:12pm

Rather than average down you can sell up and buy back in at these lower prices?

Jintray 08 Jun 2010 , 7:34pm

Here's a way to think about it. When you have decided to buy a value share, you might as well wait a bit for it to drop - if you're liking the share it seems likely that there are plenty of others thinking the same. Given that you're never going to get the bottom (well maybe sometimes if you've got time to watch a share like a hawk), you might as well split your intended investment into 2 or 3 chunks and wait for a fall each time. The idea is that, whatever price you buy at, at any time, the price is going to be lower at some stage. So buy a chunk and then wait for a fall and get a better bargain.

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