Averaging Down On A Stock Requires Mental Strength And Conviction 

I have made it no secret that I like to buy shares when prices go down. Just like you would get excited for when those trainers you were admiring go on sale, I feel the same when it comes to shares in quality comes. When prices go down, I am able to buy more shares for the same amount of money. And more shares mean more dividend income.

If prices go down further from the point at which I made my investment, I would be inclined to add to this position. Just look at my investment in Shire PLC. I first initiated a position at £44 a share. After my purchase, the stock kept falling in price. And instead of panicking, I knew Shire was getting more and more undervalued so I kept averaging down on my position and bought shares all the way down to £30 reducing my cost basis in the process. It seems that I was not the only one to think the company undervalued as Takeda pharmaceuticals made a takeover bid earlier this year at a price of between £46 – £49 a share depending on the exchange rate and Takeda stock price. I have now sold my shares in Shire this week for £44 and in the process, I made a double digit return by sticking to my guns and having conviction in the company.

The reason why I typically do not panic if the shares I own decrease in price is because I only focus my attention on quality blue chips which have strong financials, high returns on capital and an economic moat to protect the above average returns. While earnings per share could temporarily go down during a period of transition or a recession, chances are that the earnings power of those enterprises will remain intact. If the fair value of a company is the sum of all the earnings from now until eternity, then it doesn’t really matter if in one of those years the business earns £4.40/share rather than the £4.60/share it earned the year before, if I believe that earnings can rebound later.

As long as the businesses economic engine is intact and the investment thesis does not change, I have no problem averaging down on my position. 
In order to have high conviction on a business and not panic when there is a temporary blip, you need to really understand the business. You need to conduct through research on items such as historical data on earnings, revenues, free cash flow, returns on invested capital, catalysts for future growth, management credibility, technological obsolescence, trends, competition, competitive advantages etc.

If I like the business of a company like Britvic, Royal Dutch Shell or Unilever, I will get really excited if it is available for sale. I will not be scared away from a temporary weakness. This willingness to buy stocks at a discount only works with quality companies whose earnings streams are relatively immune to the economic cycle. This is why I have a preference for consumer staple stocks. Most companies in this sector make money regardless of the macro economic outlook. There is just something reassuring about investing in a stable business that produces tons of free cash flow no matter the economic situation.

The ability to buy a good company at a discount is also dependent on doing your own homework, rather than listening to someone else for stock tips and investment ideas. I hope none of you who read this website blindly follow me! You need to do your own homework in order to understand why you have bought into a particular business. By conducting research, you will be better informed in times of difficulty and you will be able to react from a point of logic instead of rashness. Without independent thinking, successful investing of any type is difficult to accomplish.

Even though I am a fan on averaging down on stocks I own as I do believe my portfolio is filled with high quality companies, there are some instances I will not average down on. For instance, I did not average down on Accrol Papers after my catastrophic loss on the stock due to the underlying business fundamentally changing. I realised that Accrol was not the quality company I thought it was and I didn’t want to invest my hard earnt money in a lost cause. 

But with most companies in my portfolio, I have successfully averaged down on my position and these have now turned into double digit returns. For me, if I like a business, and I believe that its ability to earn money is not impaired, and I believe that this business stands a high chance of operating and earning more in the next 20 years, then I will have the conviction to add to it when prices go down. Otherwise, I run the risk of trying to catch a falling knife, which could be dangerous for my future retirement based on dividend income.