QUALIPORT
Why Averaging Down Works

By Maynard Paton (TMFMayn)
March 21, 2002

"Never buy in a downtrend", "The trend is your friend", "Never catch a falling knife".

There are plenty of adages that tell investors not to 'average down' with their investments. But to the stock picker with a businesslike approach, such 'advice' is nonsense. Averaging down works.

The Qualiport has averaged down on numerous occasions. Taken from the portfolio's trade history, here are the holdings where the average 'buy price' was subsequently lowered over time:

Emap
Date         Number of Shares       Purchase Price (p)

17/04/98         169                    1,185
20/01/99          33                      875
22/10/99          99                      787.5
18/09/01         168                      582
28/09/01         147                      529

Misys
Date         Number of Shares       Purchase Price (p)

22/04/99         347                      576
01/11/99         194                      524.25

PizzaExpress
Date         Number of Shares       Purchase Price (p)

04/11/98         245                      792.5
14/06/00         226                      659.5
19/12/00         460                      645.5

Lloyds TSB
Date         Number of Shares        Purchase Price (p)

29/09/99         356                      755.5
25/09/01         128                      607

MMT Computing
Date         Number of Shares       Purchase Price (p)

06/04/00         344                      580
24/08/00         299                      552
19/12/00         450                      550

Carpetright
Date         Number of Shares       Purchase Price (p)

03/08/01         514                      578
25/09/01         161                      483.75

Johnston Press
Date         Number of Shares       Purchase Price (p)

18/09/01       1,100                      270
28/09/01         161                      243

Here's a summary of each share's average purchase price, compared to the price today:

Company      Average Purchase Price    Price Now
                      (p)                 (p)

Emap                 783.5                826
Misys                557.4                629*
PizzaExpress         687.6                779
Lloyds TSB           716.2                729
MMT Computing        560.0                120*
Carpetright          555.5                641.5
Johnston Press       263.9                396.5

(* price at disposal)

Profit

Of the seven different shares the Qualiport has averaged down on, six presently show a profit (a notable feat, given the stock market's performance in recent years).

Of course, there's the argument of the Qualiport having to average down, since it paid too high a price for certain shares in the first place. The initial purchase of Emap (LSE: EMA) valued the media firm at 30 times historic earnings. PizzaExpress (LSE: PIZ) was first purchased on a historic price to earnings ratio of 29.

But regardless of the price or valuation at which the first purchase was made, there's one key point about stock picking: Every share you buy will, at some point, fall below your purchase price.

Nobody can regularly buy shares that immediately head off higher, never ever seeing a particular 'entry price' again. Instead, you'll always be presented with opportunities to top up your favourite holdings at prices below your initial price.

Take Johnston Press (LSE: JPR). The Qualiport bought its first stake in the group at a share price at 270p, a value described at the time as "very appealing". However, just ten days later, Johnston Press shares had fallen 10%. The Qualiport duly picked up some more Johnston Press shares at a cheaper price.

Of course, you can't average down willy-nilly. You have to ensure the underlying business has not deteriorated.

For instance, in between the two Johnston Press purchases, two rival newspaper proprietors stated they had experienced no decline in their fortunes. With Johnston owning a similar stable of newspapers, that 10% mark down on Johnston's share price was unjustified.

A similar tale can be said of PizzaExpress. Following years of registering double-digit performances, the pizza chain reported sub-5% like-for-like sales growth during 1999. After the Qualiport's first purchase of PizzaExpress (at 792.5p) during 1998, the perceived slowdown of sales growth caused the shares to touch 620p in December 2000. However, PizzaExpress had announced in September 2000 that like-for-like sales growth had improved to 10%, a performance reaffirmed two months later at its AGM. Clearly, the PizzaExpress 'growth story' had not come to an end, and the Qualiport duly picked up more PizzaExpress shares at the lower price.

A good example of when not to average down is highlighted by MMT Computing (LSE: MMT). The Qualiport lost 80% on this particular investment, having bought three tranches of MMT shares during 2000. During 2001, various management changes and trading difficulties caused MMT shares to fall from 527.5p to 110p. The underlying business at MMT had changed (or to be more precise, the problems had began to surface...) after the Qualiport's earlier purchases. While it may have been tempting to top-up the MMT holding during last year's slide, there's no point buying into a company -- no matter what the price -- if you're unhappy with its underlying quality.

Summary

For an investor whose portfolio receives regular cash injections, averaging down makes perfect sense. Nobody can regularly buy 'at the bottom'. Share price declines simply offer investors another opportunity to buy suitable businesses at an attractive price.

Importantly, the key to averaging down is to ensure the quality of your chosen company has remained unchanged since the original purchase. As the Johnston Press and PizzaExpress examples show, the stock market often ignores how a company is progressing, preferring to focus on unrelated issues instead. As the Qualiport has demonstrated, such market behaviour ought to be welcomed by long-term investors.

The author owns shares in Carpetright and Johnston Press.