It’s a good feeling when you’ve found a wonderful company to invest in, and when you’ve done the research needed to decide you want to buy it. It’s an even better feeling when your margin of safety price hits, and it’s time to pull the trigger on your investment.
When that time comes, how much do you buy? 1 share? 1% of your account? 4% of your account? 20%? Do you put whatever cash you have available into that investment?
These are the type of questions we frequently receive. These are also the type of decisions you should be making before committing a single dollar into an investment. Let me explain…
When it comes to investing, managing risk is the name of the game. It’s Warren Buffett’s #1 focus, and it should be the dominant theme in your investment methodology as well.
One of the best ways to manage your risk is to decide how you will go about acquiring stock. By that, I mean what percentage of your account are you willing to allocate to a particular company, and do you want to go all-in at once with that allocation, or spread your purchases around? Deciding this before your margin of safety price hits is the key. This way, you aren’t left making emotional, last-minute decisions when a great buying opportunity comes up, trying to decide how many shares to buy, or how much of your account to allocate to an investment. If you make the decision before, then it’s mechanical—and not emotional. And the more emotional decisions we can avoid making in our investments, the better off we’ll be in the long-run.
We use what we’ve coined the “tranche acquisition method” to accumulate stock. This sounds fancy, but it’s a very simple and logical concept.
Tranche is a French word meaning portion, or slice. That’s a great word to describe our approach, as each investment is split into portions, and not all at once (except for unusual circumstances). When we employ the tranche acquisition method means we don’t make a 100%-allocated investment at any, one time, or any, one price. Instead, we buy in tranches, or portions of the total, so that we spread our risk both vertically (price risk) and horizontally (time risk).
I’ll provide a four-step summary of how it works, then put it into action to show how we turned an upside-down investment in AutoZone Inc (AZO) into a positive one with a 33% return (and counting).
1) Make a plan for how you will go about accumulating stock in a company
This means figuring out what kind of overall allocation percentage you’re willing to commit to a particular investment.
Let’s take AutoZone, for instance, and assume it’s a company you have decided you want to invest in. Are you willing to commit 5% of your total equity allocation to AutoZone (or fill in the company you want to invest in here)? 10%? 20%? For example, if you had a $100,000 account and wanted to split that up among 5 stocks, then you might put 20%, or $20,000, into each company. But we don’t want to put that $20,000 all-in at once, on our first purchase. That’s where the tranche acquisition method comes in…
2) Split each company investment into tranches, before making your first purchase
This could be split up however you decide, but we will generally split each company into four, equal tranche purchases. This means that each purchase is only 25% of the total allocation. Keeping with the above example, if we were to allocate 20%, or $20,000, of our $100,000 account to AZO, the first tranche would be 1/4th of that, or $5,000. Then each of the three remaining tranches would be $5,000 until we are fully allocated.
This allows us to spread around our risk in two ways:
- Price risk. In other words, we are confident accumulating companies at fair prices, knowing that if the price drops, we have ammo left to buy more; but if the price rises—we still have a decent amount of exposure to the upward movement.
- Time risk. Utilizing the tranche acquisition method doesn’t overexpose us at any, one, time period (bull/bear market) to a specific company. This helps avoid buying 100% into a highly-valued market (like we see today), or a highly volatile one, and it mitigates our risk of trying to time the market.
3) Make your first tranche purchase as your margin of safety price hits
Once your plan is in place, you’ve decided what amount you’re willing to allocate to a company, and how many tranches you’d like to split it up into, simply make your first purchase when that margin of safety price first hits. For us, this is usually the first of four tranches, or 25% of our commitment to a company. This should be an unemotional decision.
4) Map out your plan to acquire additional tranches
This plan could be time-based—such as every six months, or price-based—such as each 25% drop. For example, “After the first tranche of AZO, I’ll make each additional tranche purchase if the price drops 25%”. As long as the long-term story for the company remains intact, and it’s still a company you want to be invested in, then you should follow your predetermined plan to purchase additional tranches, with the goal of upping your allocation for the company to 100% of the set amount.
Turning an Upside-Down Investment Positive with AutoZone
The guiding principle of the tranche acquisition method is risk management, and recognizing that we can’t predict the future. It’s acknowledging the fact that we never know exactly how far a stock will drop in price or where/when/how far it might rise. For that reason, we want to spread our risk around over time and price.
Note that this spreading of risk can apply in various ways. In most cases, this applies to falling prices, and the method allows us to have capital ready to be deployed if, and when, the price does drop further. However, this method doesn’t necessarily mean we will only purchase additional tranches at a lower price. For example, if you don’t want to be fully allocated in the risk of “catching a falling knife” as a stock price plummets, you can pick up one tranche as the price is dropping, and further tranches once the stock looks to have found a bottom. In that case, the second tranche purchase would be at a higher price, but with much less risk. Similarly, perhaps you prefer to spread your timing risk, and spread your tranche purchases across a period of one to four years, rather than buying all at one time and overexposing yourself to the current market sentiment; this also wouldn’t guarantee a lower price, but would carry with it less risk.
In every case, however, the guiding principle is risk management.
Let’s see how the tranche acquisition method played out for us over the last 17 months with AutoZone.
When we first examined AutoZone in a July 2016 Investment Intel webinar, things were looking pretty good for the company. Financials were strong, prospects were high, and the stock was trading near all-time highs, just above $800. Based on our research and valuation, we decided $750 was a fair price to make our first tranche purchase. As noted in the webinar, we knew this was not an all-out bargain, with the enterprise multiple at 12, but we also did not want to miss out on further gains should the company continue to perform well—as we expected they would.
A couple of months later, in September 2016, AutoZone hit $750. We were in.
Why were we comfortable paying a price which we acknowledged was not a smokin’ deal? Because we had the tranche acquisition method in our pocket. Making a 100%-allocated investment at $750 would not be a decision we’d be comfortable making (it was only a fair deal); but making a ¼ tranche purchase absolutely was.
Here were the possible outcomes…
- AutoZone takes off from $750 and continues its’ march higher, as it had done since 2009. If that were to happen, we would have money on the table to participate in those gains, though only a small amount. The stock going up would be nice, but we wouldn’t want a full position at this level, since it’s not yet a great deal. We would only want a portion here, to profit should this scenario of the stock continuing to rise play out.
- AutoZone hovers around $750 and fails to pick a direction for a while. In that case, there wouldn’t be any gain, but also wouldn’t result in a loss.
- AutoZone drops well below $750. Our ¼ tranche position would be losing money, but we would still have ¾ of our allocation left. We could buy more as the price drops, as long as we believe the long-term story of the company is still intact.
As it happened, scenario #3 is how things played out. The stock plummeted. Down 34% in 10 months.
And we were thrilled. Why?
The first scenario would have been good. If the stock continued higher, well then we bought a great company at a fair deal and made a decent profit.
But as the stock plummeted toward $500 and the long-term future of AutoZone continued to be strong, we suspected we were given an opportunity to make a lot more. Scenario #1 would have been good; scenario #3 was potentially great.
Upon analysis in July 2017, we opted to purchase another tranche at a price of $495.
By this time, we were two tranches in, which made for half of our full allocation. This also lowered our basis (average price paid) in the stock by a significant amount, from the initial $750 down to $590. Let me walk through the math, keeping with $20,000 (20% of $100,000) as the example figure…
First tranche (6 shares @$750 = $4,500) (7 shares would have put the amount over the allotted $5,000)
Second tranche (10 shares @ $495 = $4,950)
Total invested = $9,450 to acquire 16 shares
This is how the cost basis was reduced to $590. $9,450 divided by 16 shares. Whereas with the initial purchase, we would have needed the price to rebound from $495 to $750 just to breakeven, we could now breakeven and begin to see gains at the $590 level, just $95 above the second tranche purchase price.
At this point in July 2017, we were faced with the same three scenarios as before, only with the price of $590 replacing the original $750 price.
Think about that. We still felt very good about the company, as indicated to Investment Intel members. Sure, AutoZone was going through some struggles, as investors worried Amazon could eat significantly into profits, and brought their price down along with every other brick and mortar retailer. But we looked at these as short-term problems. We felt confident, and still do today, that they would solve these problems and come out better in the long-run. That long-term mentality is what gives us the edge, and what allows us to buy a stock like AutoZone in the face of fear, amid a major price drop which hadn’t yet found a bottom. That, along with the tranche acquisition method.
The market had given us, as margin of safety investors, a tremendous opportunity by driving AutoZone’s price down. The best scenario, once again, would have been if the price were to keep dropping from $495. This would have allowed us to accumulate more shares, since that was the plan we had in place; we only wanted to be fully allocated at true, deep value levels to manage our risk in AZO and position our accounts for maximum gain.
But the price didn’t drop. In fact, it shot higher, as investors realized the Amazon fears were exaggerated and more accurately valued the excess cash-flow the company produced. As of today, the stock price sits at $788.
With 16 shares at a current price of $788, the total investment of $9,450 in AutoZone is currently worth $12,608. This represents a gain of $3,158 on a $9,450 investment, for a total return of 33.4%. While our initial tranche was once down 34%, making that second tranche purchase enabled us to turn the upside-down investment positive with a 67.4% swing.
Had we simply kept the original purchase, we’d be up 5%, or just $228 on the original investment.
Can you see the importance of accumulating stock in great companies as their price drops? That’s the power of the tranche acquisition method.
AutoZone is a company we’ll continue to update our analysis on with Investment Intel members to see when the right time to sell might be, or if it might be time to add additional tranches.
When it comes to optimizing returns in your investment account, your first consideration should always be “how can I control and reduce my risk”? The tranche acquisition method is a systematical way to do so, provided you follow the rules, plan out your purchases and method ahead of time, and periodically update yourself with the latest news and analysis of the company to be sure it’s an investment you want to be involved with. We encourage you to see how it can fit into your own investment approach.