Building Positions

Jerome writes:

I notice from your stock book that you advocate buying more shares of a good company when its stock price drops. I was wondering if you’re doing any of that these days, and if you could explain a little more about the approach.

Yes, I’m doing a lot of it these days. I’m finding bargains in chip stocks, health care stocks, restaurant stocks, the financial sector, and home builders. I also think Japan is poised for a nice run, and am looking for both the right vehicle and right time to benefit from it.

Like Bill Miller at Legg Mason, I average down relentlessly. I rarely stop out of positions as they fall and, when I do, it’s usually when they’re looking likely to fall from a high point of gain. Rarely, such as when I took a flier on speculative stock Charles & Colvard in late 2006, I’ll set protective stops to guard against catastrophic loss.

In general, though, I’m on the hunt for good businesses selling at a discount to their future potential. If I can increase that discount by lowering my average cost per share, I will. This requires faith in the company behind the stock, but I almost always have faith in the companies I own. I write “almost” because I have speculated occasionally on mere price movement alone, as mentioned above. That is the exception, however, not the rule.

If you believe in a company based on thorough research, and fresh data continue supporting that belief, then a price lower than what you initially paid for a stock is a chance to improve your ultimate performance.

Volatile times such as this one around the sub-prime credit crisis are ideal for doubling down, building positions, lowering average cost paid per share. I’ve been building positions in The Kelly Letter and I wrote to subscribers that I will continue doing so as long as the bargains persist. We are not alone. Smart money around the world is taking advantage of cheap share prices.

To wit: Abu Dhabi based Mubadala Development bought 49 million shares of Advanced Micro Devices at $12.70, the Abu Dhabi Investment authority bought 4.9% of Citigroup, China Investment Corp. bought 9.9% of Morgan Stanley, and Goldman Sachs bought 20% of First Marblehead. Bill Miller has been buying shares of beaten-down homebuilders Centex, Lennar, and Pulte Homes.

Kelly Letter subscribers and I have also been taking advantage of price weakness to buy shares of AMD and Marblehead. We’re building positions in them to benefit even more when they eventually recover. We’re also trying to get Starbucks on the cheap, as well as the entire financial sector and real-estate related bargains, as I mentioned above.

While this may make sense on screen in the calm of your home or office, it’s harder to keep perspective when prices are falling. I inevitably receive harsh notes of criticism when a position I own falls below my initial buy price and I add more to it. I inevitably receive glowing notes of praise when that very same position rises later, and all memory of the process that led to the gain is forgotten.

I saw a small bit of that at work last month. I had saved a critical mass of angry notes regarding First Marblehead that I intended to address one weekend. Yet, the tide turned on the Friday before and the majority of those same angry note writers followed up with congratulatory notes when Marblehead rose 66% in a day on news that Goldman Sachs was investing in it and providing a cash infusion. I went from bonehead to brilliant overnight.

I’m neither. I did not invest in Marblehead with the knowledge that Goldman Sachs was also watching it. I invested in it with an understanding of its business model, the recognition that it would one day sell securitized student loans again, and an eye on its stock price history which showed recovery from just such depressed levels as we saw during those dark December days.

Funny thing is, that’s the same thought process that led me to invest in IBM several times for an eventual multi-bagger profit during its long recovery in the 1990s, Decker’s Outdoor for a 40% gain in two months, Intel for a 64% gain in 10 months a few years prior and again for the 32% gain that we were sitting on last month, and so on.

By the end when we sold, I was considered brilliant. During the process during which we bought at prices lower than my first purchase, I was considered a bonehead.

Knowing this, I encourage subscribers to see the negative performance of some of The Kelly Letter’s positions from time to time as opportunities, not failures. If I’m not a seller of them as they fall, I’m a buyer. I’m building positions in the stocks.

An example from outside the letter’s experience may help.

A good friend of mine loves Apple and he invested in the company during the end of the boom in 1999 and sold at around $30 in early 2000. The stock fell with all else tech and he waited for it to bottom out. He thought it had done so in December 2000 at $8. Then it rose.

That was the breakout, he decided. He knew the company had revolutionary products on the way. He bought at $12 the following April. The stock fell back below $8 again over the summer. On paper, he was down more than 33%. A bonehead, right?

Not exactly. He bought again and lowered his average cost per share to less than $10. It took months for the stock to get back up to $12 in January 2002 and then you know what happened? It fell for more than a year to less than $7 in April 2003.

After holding Apple for two years, he was down more than 35%. What did he do? He bought a third time, lowering his average cost per share to less than $9.

Was he early? Yes. Was he wrong? No.

Apple shares closed 2007 at $198. My friend’s too-early, boneheaded investment gained more than 2,000% in seven years and eight months. He was thrilled that he bought three times, but wished he’d bought ten times.

My friend and I are not traders. If you subscribe to The Kelly Letter, neither are you. We are investors. We don’t automatically stop out at -8% as some famous books suggest. We don’t automatically sell at +20% as some other famous books suggest. We find good businesses coming back from the brink, and we build positions in them.

It requires minus signs along the way and can stretch emotions, but this approach works. It doesn’t happen overnight, though, and to the instant gratification mindset of a trader, it’s unacceptable. To the investor, it’s great.

Recently, the internet has allowed short-term trading services to proliferate. Most of the “research” proffered online amounts to daily speculation, with the latest trend being the odds of certain stocks and indexes rising tomorrow. Those odds are often clustered around 50%, you’ll note, rendering the data all but meaningless. It’s still popular, I’m afraid, and sells well to the gullible.

Don’t fall for it. The wealthiest investors are those with multi-year time frames. That’s enough distance to provide the perspective needed to jump on short-term weakness for long-term gain. If you think you can buy today on hopes of what will rise tomorrow, and succeed at it consistently enough to overcome taxes, trading fees, and odds of failure at 50%, there’s nothing I can do for you.

My friend acquired shares of Apple over a two-year, rocky period with all kinds of doubtful headlines. You should not underestimate the fortitude it took to keep buying when papers reported that the market might never recover from the bust. Remember, Apple is a technology company and was part of the out-of-favor crowd at that time, and the meltdown was one of the worst bear markets of all time. The Nasdaq plunged 78%, after all. It doesn’
t get much worse than that.

So, take heart when volatility sets in and weighs heavy on your portfolio. It’s a tool to be used, not a risk to be feared. Understand that a buyer prefers low prices, not high, and that low prices don’t come with happy headlines.

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