Throughout 2022, cash levels within the Mash Global portfolio have been unusually high. Actually, the highest they have been since inception.
Based on our public writings since April 2021, it seems we anticipated the subsequent global market carnage and given our long-only format (prior to our recent Fund launch), we chose to ‘observe from the side and skip the ride’.
However, as the market has been declining over the past few months, one question may have been circling the minds of our prudent U/HNI and family office investors:
Given that we have a long investment horizon and that we cannot reliably time the market, why not deploy cash in tranches and keep averaging down?
Context.
The phrase ‘averaging down’ refers to the notion of buying more when an asset’s price goes down, thereby reducing the overall purchase price. It’s an approach made famous by Mr. Buffett, who professed that if you like a stock at $10, you should love it at $5.
Sadly, I’ve seen plenty of investors delude themselves into thinking they are indeed Mr. Buffett and fall victim to this approach.
My approach and counsel remains straightforward -- in general, do not average down. Before I elaborate though, allow me two caveats:
First, this note is about averaging down on a particular position. A particular asset. Or a business in your overall portfolio. It does not apply to your overall investment program of dollar-cost averaging or systematic investment plans.
And second, this note, while appearing tactical, is not at all intended to downplay the importance of fundamental research and analysis while evaluating partial ownership in a business (or an asset). In fact, the averaging down guidelines shared herein are perhaps best absorbed and practiced successfully only after a thorough understanding of the fundamentals.
Now, let’s get back to the notion of averaging down. Let’s use some numbers and narratives to drive us toward an answer. Numbers first.
Numbers.
Assume you’ve conducted fundamental research, built an investment hypothesis – essentially a story you believe will hold – and you’re ready to deploy capital.
Based on your odds of success and a multitude of criteria that your investment approach entails, you’ve decided to allocate $100 to this position. You may choose as many tranches as you like. For simplicity, let’s keep 2 tranches at $50 each.
Assume you have a strict drawdown limit for your investment position -- after all, you are a prudent investor, right? For simplicity, let’s keep it at 20%.
Now, say you’ve deployed the first tranche – 5 shares at $10/share for a total of $50. And the price keeps going down. $9/share. Then $8/share, a 20% drawdown from your first tranche price.
What do you do?
Let’s think through this using six different scenarios.
Scenarios | Story holds | Story fails |
Average down | A | B |
Do not average down | C | D |
Sell at limit | E | F |
Scenario A.
You average down at $8/share and your story, your hypothesis holds. Therefore, in an ideal world, price doesn’t materially decline below $8/share.
Tranche 1. $50 at $10/sh = 5 shares
Tranche 2. $50 at $8/sh = 6.25 shares
Total shares = 11.25 shares
Current share price = $8/sh
Current market value = $90
Current drawdown = 10% of max position
Scenario B.
You average down at $8/share and your story, your hypothesis does not hold. Therefore, in a theoretical world, price declines to $6/share.
Tranche 1. $50 at $10/sh = 5 shares
Tranche 2. $50 at $8/sh = 6.25 shares
Total shares = 11.25 shares
Current share price = $6/sh
Current market value = $67.50
Current drawdown ~33% of max position
Go through Scenarios C through F (as shown in A and B above) and this is what you get in terms of drawdowns for each of these six scenarios:
Drawdowns | Story holds | Story fails |
Average down | 10% | 33% |
Do not average down | 10% | 20% |
Sell at limit | 10% | 10% |
Similarly, cash remaining in each of these six scenarios:
Cash remaining | Story holds | Story fails |
Average down | 0% | 0% |
Do not average down | 50% | 50% |
Sell at limit | 90% | 90% |
Now combine these two tables and let’s evaluate these six scenarios. I believe evaluating these via narratives will be more effective.
Narrative.
Scenario A.
You’ve taken a notional 10% hit and have no additional money in your pocket now. You’re all in. Your story better hold!
Scenario B.
You’ve taken a notional 33% hit and have no additional money in your pocket now. Your story does not hold, so you’ll likely convert this notional loss into an actual one.
Mental bandwidth stuck on a difficult cause (you now need to earn at least 50% before you break even). Emotional pain. And perhaps you even miss better opportunities. Bad spot!
Scenario C.
You’ve taken a notional 10% hit and have an additional $50 in your pocket now. In other words, you still have 50% of your dry powder.
You are rooting for the story to hold but it’s not the end of the world if it doesn’t. You’re more or less indifferent, that’s a good spot for an investor!
Scenario D.
You’ve taken a notional 20% hit and have an additional $50 in your pocket now. Your story doesn’t hold, so you’ll likely convert this notional hit into an actual one.
Not great but manageable, part of the game, let’s do better next time you say. Not bad, right?
Scenario E.
You’ve taken a 10% loss but have an additional $90 in your pocket now. In other words, you still have 90% of your dry powder. You are observing the story and evaluating what you may have missed.
If you find the story still attractive, you have a 12.5% price buffer ($8/share to $9/share) before you could deploy the entire $90 and be in the same situation as someone who averaged down. Decent position to be in!
Scenario F.
You’ve taken a 10% loss but have an additional $90 in your pocket now. In other words, you still have 90% of your dry powder. You are observing the story and evaluating what you may have missed.
If you find the story still attractive, you have a 50% price buffer ($6/share to $9/share) before you could deploy the entire $90 and be in perhaps a much better situation as someone who averaged down at $8/share and their story holds.
And of course, if you do not find the story attractive, learn your lesson, keep $90 in your pocket, have no energy drains, and simply look for a better opportunity. Either ways, it’s a good position to be in!
This is what the final table looks like, from an investor’s experience and feeling perspective:
Investor's feeling | Story holds | Story fails |
Average down | Good | Bad |
Do not average down | Decent | Decent |
Sell at limit | Decent | Good |
Observe that 'Sell at (drawdown) limit' is actually a subset of not averaging down plus having an excellent risk control discipline in place.
It should not come as a surprise when I mention that Mash Global generally operates in the bottom four scenarios, especially when positioned defensively.
A natural question then arises: Does Mash Global ever consider averaging down? If yes, under what conditions?
Average down, if you must.
That’s a work in progress. So far, in my view, there are five criteria that must be met before Mash Global may average down while ensuring a favourable risk-reward balance.
1. Simple business model
2. Clean balance sheet
3. Predictable cash flows
These three criteria generally lead you to mature, dividend-paying businesses. It’s a similar fabric to Ben Graham’s “the large, temporarily unloved company” reference.
Typically, these businesses grow earnings moderately and are not your hyper-growth, cash-burning names. In general, averaging down here may work well.
That said, there are two criteria that are equally important to avoid when considering averaging down. Allow me to elaborate on both of these.
4. No business continuity risk
Imagine a competitor that shows up with a significant breakthrough. Consider a business at the cutting edge of science. What if a scientific breakthrough that essentially wipes out your existing biotech business?
Similarly, consider a business at the cutting edge of technology. In the older days, visualize Kodak. In today’s age, just look at the underlying holdings of ARK Innovation ETF during 2021 and 2022. Despite Ms. Cathie Wood averaging down every day on several holdings (yes, every day for a few weeks), price declines crossed 60%, 70%, 80% and even 90% in many cases.
Imagine a business that carries regulatory risk of an autocratic regime. Consider the Chinese education sector. What are the odds of your business continuity?
Needless to say, averaging down whenever there is any kind of business continuity risk is a really, really bad idea. At least for the prudent investor.
5. No leverage
This one’s easy. But it is also easily misunderstood.
When I say leverage, it’s not just external leverage. Several business models have inbuilt leverage. Take financial institutions like banks as examples.
Even Mr. Buffett is extremely careful here. The story goes that during the Global Financial Crisis of 2008-09, a bunch of Irish banks collapsed 90%. Berkshire famously couldn’t resist the lure and bought in.
After Berkshire’s purchase, these banks collapsed another 50% (essentially down 95%). At this point, the living legend who made a strong case for the averaging down approach, chose to not average down.
I think he knew that when you are dealing with leverage, it’s a deadly mix. Literally deadly. As Munger quips, “all I want to know is where I’m going to die, so I’ll never go there”.
Fortunately, we use this quote from Munger more than once in our Mash Owner-Investor Guide. We avoid leverage like the plague, so I don’t foresee us having to even make the decision of averaging down here!
That's a wrap!
That’s all I know and practice so far. As I evolve as an individual and as an investment professional, I will update my beliefs. For now though, I trust my narrative explaining “in general, do not average down” helps.
And yes, to succinctly answer the question that prompted this rather detailed note: “for now, simply wait – do not average down.”
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