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The Risks of Doubling Down on Falling Stocks

InvestorEducation / Learning to Invest Sep 09, 2007 - 01:03 AM GMT

By: Roger_Conrad

InvestorEducation

Best Financial Markets Analysis ArticleI know a few people who know when to double down in Blackjack. A lot more, however, lose their shirts in an emotional attempt to make back losses.

Even those who usually succeed will freely admit doubling down isn't a risk-reduction technique. On the contrary, you've got twice the money at stake, betting on the same situation. You may recoup your losses in one fell swoop. But the penalty for failure is twice what it was before, and it's hard not to get a little emotional.


Emotions are as much a killer in investing as they are in gaming.

Greed is always a threat to keep us in the game too long or an inducement to take on too much risk. Fear can keep us from taking action when we most need to.

One of the least emotional ways to invest is through dollar-cost averaging, particularly through dividend reinvestment plans (DRIPs).

I personally have positions in a dozen plans, and I don't do anything with them but let them accumulate shares.

It's not a suitable strategy for every kind of stock, and you do have to monitor your holdings to make sure the long-term fundamentals are still strong. But if you have good companies backed by the strongest kind of businesses--the Super Oils or selected utilities, for example--you can pretty much count on them becoming more valuable over time. Using their DRIPs to reinvest dividends lets you buy more shares when prices are low. And you buy fewer when prices move up.

In stark contrast, averaging down is probably one of the most emotional ways to invest. Basically, averaging down involves buying more of a stock you own when it drops in price. The idea is it's considerably easier to make back losses in the earlier position by entering again at a lower price.

Make sense? Well, maybe if you're betting on the overall market or a particular sector. Doing it with individual stocks, however, is fraught with risk. That's because unlike market or sector plays, individual stocks carry unique risk, or potential problems exclusive to their own operations. You can be dead right on the trend. But something you don't know about the individual company can still sink you anyway.

In that sense, doubling down at a casino is actually far less risky than averaging down a stock. At least there you know the odds are stacked in favor of the house and all the variables are in a deck of cards, not a courtroom situation or backroom accounting operation that will only come to light after it's too late.

For the essential service infrastructure and utilities businesses, you don't have to go further for an example of disastrous averaging down than the 2001-02 bear market. How many people kept buying ENRON and WORLDCOM on the way down, only to see their investments basically go to zero?

Both companies are household jokes now, and you won't find many people owning up to recommending them. But at one time, Wall Street was almost universally bullish on them. Their credit was rated A by S&P and Moody's. Banks run by extremely intelligent people practically threw money at them.

Perhaps most impressive, they had succeeded in convincing their industries that theirs was the wave of the future--and that everyone else had better copy them. In effect, their apparent success was responsible for the massive mountain of debt piled up in the communications and energy utility sectors, a pile that has only been paid down after five years of very heavy lifting.

When Enron and WorldCom peaked, there was absolutely no indication in their numbers that their business models were crumbling. A handful of short sellers were asking some very good questions. But the worst thing you could say about either was that the market had become, to paraphrase former Federal Reserve Chairman Alan Greenspan, “irrationally exuberant.”

That, in fact, was my objection to buying Enron anywhere close to its ultimate peak. I did, however, fall into the trap of re-recommending the stock after it had fallen back to the 40s. At that point, the company's earnings numbers were still super bullish.

But those who followed my lead back in were soon faced with a stock that had fallen by half.

Temperamentally, I'm always inclined to get more bullish on a stock when it falls. And buying more of a particular utility stock after a tumble has, historically, been a strong strategy. In fact, it's been a virtually infallible technique for scoring big gains since the utility industry came into being more than a century ago.

In literally every instance where a utility has gotten into trouble, it's been able to make itself whole over time by cutting debt and operating risk, repairing relations with its regulators and improving essential service operations. That's what's happened during the past five years as utility after utility has made it back to financial health.

This year, two of the most battered companies of the 2001-02 bear market--CMS ENERGY and SIERRA PACIFIC RESOURCES--both resumed paying dividends for the first time since their meltdowns. CMS regained an investment grade credit rating, while Sierra also scored upgrades.

That's truly remarkable when you consider that both were near bankruptcy in early 2003. Disastrous diversification, too much debt and poor regulatory relations took them down. Getting back to basics built them up again.

Enron and WorldCom, however, were not pure utilities. But the real thing that did in investors was that management lied. Investors didn't have the information they needed to make a rational determination of risk and reward, and therefore a rational decision about what to do.

That, in a nutshell, is the risk you take when you average down or double down on a particular stock. Moreover, even those who averaged down in the situations that ultimately did recover--for example, CMS and Sierra--have had to wait a long time to make their money back from averaging down during the crisis. I'll bet most who tried gave up well before their respective recoveries unfolded.

For me, the 2001-02 experience is still very fresh and raw. As far as utilities go, I've rarely been more encouraged with sector fundamentals after five years of intensive deleveraging and improving industry conditions, but I'm still not going to double down on a stock that stumbles.

I won't necessarily give up on it. If the underlying business is sound, I'll stick around. If I have more money to invest, however, I'd rather put it in another stock with another set of risks and potential rewards. I'm spreading my bets, not concentrating my risk.

And if I catch wind that business fundamentals are deteriorating, I'm out.

There are too many other great bargains out there to get emotionally attached to a loser. We want long-term relationships with our stocks. That's the only way to reap a high income stream and realize the benefit from owning a growing business. But we're not marrying them, either. There's no emotional commitment.

I don't believe in hard stops for income stocks. There are too many market variables that can send prices up or down for no reason, and it's pointless to set yourself up for a good old fashioned whipsawing. But if the business fundamentals deteriorate, it's time to go. That's the lesson the markets teach us over and over again.

And those who let emotion stand in the way of listening to it do so at their peril.

LESSONS OF THE PAST

What's this bit of market history have to do with today? Plenty, apparently.

This week, I've been speaking at the Washington, DC Money Show, a delightful forum of investment professionals and a great place for me to talk to readers and other investors face to face.

One thing I'm hearing a lot about is averaging down. This summer has obviously not been kind to the markets, including a large number of income generating plays. Even utility stocks--though still generally up year to date--have taken on some water. US real estate investment trusts (REITs) have been slaughtered, as have most flow-through entities (which pay dividends out of pre-tax cash flow) and many closed-end bond funds. Anything to do with natural gas has basically been taken out and shot.

I'd be the first one to say there are a lot of bargains in these investment groups. And my firm belief is people are going to make a lot of money betting on their recovery in coming months.

Risks remain, however. As this week's numbers indicate, the US mortgage market is still floundering, and things could well get worse in the near term. And although most economic indicators are relatively buoyant, there are signs of slowing, such as the drop in payrolls.

Encouragingly, unemployment insurance claims have actually dropped, and that's really the only hard data on the employment picture as payrolls are based on surveys. But the Friday employment report has had a big impact on the stock market, pushing down bond yields and share prices.

If this crisis does worsen, the stock market will almost certainly come down further, and even the best-run companies won't be wholly spared the damage. The difference is companies with solid fundamentals will survive the near term and, when the dust clears, will move on to higher territory.

The only real worry income investors have is getting stuck with something where the fundamentals really are coming apart.

Unfortunately, the only time really bad news does come to light is during times of economic and market turmoil. And that plays right into the psychology of doubling down.

The people hurt worst during the utility market meltdown of 2001-02 were those who kept raising their bets on the way down. Those who simply let existing positions ride suffered. But with other income investments such as bonds and REITs surging, their overall portfolios hung in there.

This time around, utilities aren't the market's trouble spot. After a decade of reducing risk by cutting debt and exiting non-core operations, they're actually among the safer places to go. Even in the utility space, however, there are potential problems with certain companies that can punish those who overdo it.

Outside the utility sector, there are no such assurances. Financial companies are basically black boxes, and the assets they invest in are under their greatest stress in a decade. The odds of another major player in the mortgage market or banking sector blowing up are going to be high as long as the US economy and mortgage market are weak.

Some positions make sense. But averaging down on losers is where the really big losses in Enron and WorldCom--and other blasted out companies--were made during 2001 and 2002. And it's how the really big losses will be made this time around in the event that the macro picture worsens, as the bears suggest.

The bottom line for investors remains the same: Stick with high-quality positions in a range of industries, particularly those that generate high income protected and fueled by healthy growing businesses.

If you're inclined to bet on sectors, the safest area right now is essential service infrastructure. The industry is as deleveraged as it's been in decades, both in terms of operating risk and debt. And people will keep paying their power, communications and water bills long after they slash discretionary spending.

My favorite high-potential play is natural gas. My colleague Elliott Gue has written extensively on the subject in his weekly e-zine The Energy Letter ( http://www.energyletter.com ). My view reflects his that we're due for a recovery in this extremely battered sector.

My favorite bets in energy are Super Oil stocks, and I own several.

There's very little that ever knocks these things down for long.

Their balance sheets are the strongest in the world. Their reach in the energy market is unmatched, and their product remains absolutely critical to a functioning world economy. The best Supers are those with a rising production profile and that means CHEVRON, which has several projects going on around the world.

On the riskier side, I like ENERPLUS RESOURCES, the producer Canadian trust. The company is superbly managed, evidenced by a 20-plus year track record of weathering all manner of environments for energy. It pays a huge dividend yield of around 10 percent and it's poised for rapid growth in Canada's tar sands production, as well as the prolific Baaken region for conventional oil.

The shares sell for far less than I believe they're worth for two reasons. One is there's a real concern a US recession could hurt oil and gas prices further. The second is lingering worries about taxation in 2011.

At the DC Money Show today, I had the opportunity to moderate a panel of Canadian trusts, including a representative of Enerplus. He again affirmed the trust's intention to remain a high-dividend paying company in 2011, even if the current tax law isn't changed before then. He also affirmed the trust's actual tax rate would be far below the 31.5 percent statutory rate, which would enhance its ability to pay big distributions well past 2011.

Battered markets aren't for everyone. And the market action of the past several weeks is nerve wracking to say the least. The Dow's 250-point loss on Friday carried over into virtually all markets, though oil and gas commodities were actually up on the day.

The key, however, is the Federal Reserve is pumping money into the system. It may not move as fast as many would like, and there will be days like today, when nothing outside of Treasury bonds rallies.

Today, for example, the 10-year Treasury note yield sank to its lowest level in many months at 4.37 percent, as investors panicked from everything else.

Sooner or later, however, pumping in money will do its work and we'll see a rally. Utilities are likely to be among the first beneficiaries. In the meantime, they'll hold their own as dominant providers of essential services.

Hang in there.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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