When Should You Average Down?






When Should You Average Down?

 

Value Stocks and Growth Stocks

 

A Favorite Growth Stock

 

 






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I received the following email from a reader this week.

 

“When you get time (!) could you elaborate on why
you don’t average down on growth stocks? 
I’ve heard two “experts” in the last two days saying to
average down on good stocks.”

 

D.B.

Portland, Oregon

 

This is a great question, because it gets to the heart of
the reason we own particular stocks. 
And the key is right there in the question, in which D.B. refers to
“growth stocks” and “good stocks,” phrases that are not
always interchangeable.

 

In Cabot Top Ten Report, which recommends 10 strong
stocks every Monday, a “good stock” is one with a strong chart and a
great growth story, like Netflix (NFLX) today.

 

Netflix, which revolutionized the home video-watching
industry once and is now doing it again streaming content online, saw revenues
grow 26% in the latest quarter, saw earnings jump 63%, and has analysts
projecting earnings growth of 32% (which is probably conservative) in
2011.  The company’s after-tax
profit margin typically runs around 7%.

 

So NFLX trades at a typical growth stock valuation.  Its price/earnings ratio is 45 and its
price/sales ratio is 3.2; to buy this business, which had revenues of $1.77
billion in the past 12 months, the market says you’ve got to pay $5.62 billion
(3.2 times sales)!  Some analysts
call this markup the “growth premium.”

 

And Netflix is not unusual; the best growth stocks always
seem expensive.

 

Meanwhile, in Cabot Benjamin Graham Value Letter, a
“good stock” is one with a proven business model and experienced
management that is selling at unusually low valuations, like Archer Daniels
Midland (ADM) today.

 

Archer Daniels Midland is one of the biggest food and
grain companies in the world, and it pays a reassuring 2.4% dividend (the
company has raised its dividend for the past 34 years).  But revenues grew just 3% in the first
quarter, and analysts are projecting earnings growth of only 1% in 2011, and
the company’s after-tax profit margin typically runs around 3%.

 

So ADM trades at a typical value stock valuation.  Its price/earnings ratio is 10 and its
price/sales ratio is just 0.26; to buy this business, which had revenues of
$62.5 billion in the past twelve months, the market says you’ve got to pay
“only” $16.3 billion!

 

And ADM is not unusual; the best value stocks always look
cheap.

 

So, to recap, to a growth investor, NFLX is a “good
stock” because it’s strong and because the company has great prospects for
growth of both revenues and earnings.

 

And to a value investor, ADM is a “good stock”
because the company has a proven business model and experienced management and
the stock is cheap today.

 

But what about D. B.’s question about averaging down,
meaning buying more stock at a price lower than where you previously bought it?

 

Averaging down makes perfect sense in a value stock like
ADM, given that there’s confidence the stock will be higher eventually, if not
immediately.  Most recently, in
fact, ADM has been trending down. 
It was trading at 33 back in November, and now it’s down to 25.  Cabot Benjamin Graham Value Letter
editor Roy Ward says the stock is a good buy anywhere under 28.11, so it makes
sense that you’ll get an even better bargain if you can buy more (average down)
at 24 or 23 or 22.  Value stocks,
in that sense, are like bananas. 
Cheaper is better.  And
unlike bananas, stocks don’t go bad a week later.

 

But good growth stocks can seldom be bought cheap, and as
long as their prospects for growth are intact, a high valuation is no reason to
avoid investing.  NFLX, to return
to our example, was an expensive stock six months ago when it was trading at
55, when it earned a spot in Cabot Top Ten Report; it’s been expensive in the
three occasions it’s appeared there since (trading at 59, 65 and 98); and it’s
even more expensive today trading above 110.

 

The right way to play NFLX, and the right way to play all
the best growth stocks, is to buy more stock at higher and higher prices
(averaging up) as the months go by, holding on tight until you decide the
uptrend has ended.

 

By contrast, consider Research in Motion (RIMM), the
maker of the Blackberry.  RIMM used
to be a great growth stock … before Apple came out with the iPhone.  And by the numbers, Research in Motion
is still a decent growth company; revenues were up 18% in the first quarter,
and earnings grew 42%.  But that
alone is not enough to make it a good growth stock.  The main problem, as I see it, is that RIMM was once
well-loved, but growth is now slowing. 
In fact, analysts are projecting earnings growth of 24% in 2011 and only
9% in 2012. 

 

So investors have been reacting to the expectations that
Research in Motion will be a slower grower by slowly and steadily moving
elsewhere, to stocks like AAPL and NFLX.   As a result, RIMM has underperformed the market for
the past two years; it was trading near 150 two years ago; it was at 86 one
year ago, and now it’s near 60. 
And as a result of that, the stock’s growth premium has shrunk.  RIMM’s price/earnings ratio is now down
to 13, and you can buy the company for $34 billion … or 2.3 times sales.

 

So if you had been averaging down in RIMM over the past
two years, you might not be very happy today.

 

Bottom line, averaging down is fine for investors in
value stocks, but dead wrong for investors in growth stocks.

 

Note: Eventually, if RIMM’s downward trend continues, it
could be a good value stock, but the transition period from one phase to the
other is usually too long (many years) for most mortals to tolerate.

 

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As to the stock market, here’s the way I see it.

 

By the end of last week, the market had become ripe for a
powerful bounce.  That bounce began
yesterday, and continued today.

 

The correction, which had the indexes down 14.5% at the
bottom, was sharp, swift and accompanied by plenty of bad news, including a
volcano (now two), a massive oil leak, continued high unemployment, a troubled
euro zone, and more.

 

All that is pretty normal for a correction.

 

But what was unusual was the action of leading stocks,
many of which simply refused to participate in the correction!

 

These stocks were held tight by institutional investors
still expecting a brighter future at these firms.  And whenever individual investors scared by the market’s
plunge sold and headed for the safety of cash, these institutional investors
bought more, supporting these stocks and keeping the positive chart patterns
intact.

 

So now these stocks are in stronger hands than previously,
and they’re primed to resume their previous advances as the pressure comes off
the broad market.

 

One of my favorites is a company called Akamai (AKAM),
which recently earned a spot in Cabot Top Ten Report.

 

Here’s what editor Mike Cintolo had to say.

 

“Akamai delivers roughly 20% of all Internet
traffic, acting as the main intermediary between you and content providers like
Adobe, Clear Channel, EMC, Fox Interactive, MTV Networks, MySpace, Nasdaq, NBC,
Sun Microsystems, Starz Entertainment and Verizon Wireless. Using a global
platform of thousands of servers, it delivers content and applications on
demand, always working to stay ahead of the world’s appetites, which continue
to grow rapidly, thanks in part to the explosion of high-definition (HD) video
and music from companies like Netflix and iTunes. Also driving demand are HD
sports (the Masters golf tournament generated traffic exceeding 3.4 terabits
per second over Akamai’s network), cloud computing, and the boom in smart
phones. After 10 years in business, Akamai is poised to top $1 billion in
revenues this year. Profit margins are very good, and the future is
bright.”

 

When that recommendation appeared on May 10, AKAM was
trading at 38.  In the weeks that
followed, it continued to build a base under 40.  But yesterday it broke out above 40, on good volume.  This is a classic sign of a leader;
even though the general market is only a few days off its lows, AKAM is hitting
new price highs!

 

Just beware; if you buy AKAM, you should have a sell discipline
in place, and the best way to get that is to become a subscriber to Cabot Top
Ten Report, which provides regular updates on all past recommendations until
they are sold.

 

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Yours in pursuit of wisdom and wealth,

 

Timothy Lutts

Publisher

Cabot Wealth Advisory

 

 

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