10 Rules For Catching Falling Knives & Increasing Returns

November 7, 2017

10 Rules For Catching Falling Knives & Increasing Returns

  • The S&P 500 is constantly ascending to new highs, but there are plenty of stocks setting new lows.
  • Today, we’ll discuss how to approach such a situation from a behavioral and technical perspective.
  • The 10 rules that follow will help you increase your batting average.



Introduction

Despite the fact that the S&P 500 has only been going up lately, there are many companies that have had a terrible time, especially if you look at retail stocks. But this opens the door for a very interesting investing strategy of trying to buy stocks at their bottom after a price drop or more simps, to “catch a falling knife.”

In today’s article, we’ll discuss this strategy in depth, discuss a few current stock examples, and come to a conclusion about whether we should even apply such a strategy.

Catching A Falling Knife

A stock that has experienced a fast drop is usually called a falling knife. In a bear market, the whole market can be a falling knife.

A stock can decline for multiple reasons, be it missed analysts’ expectations, sector issues, accounting issues, negative investing sentiment, legal issues, or many other possible negative impacts.

The hope behind the catching a falling knife strategy is to buy a security when it is oversold and the actual (intrinsic) value is much higher than the resulting stock price. This happens very often as investors are irrational and tend to overreact to negative news.

Our thinking is exclusive, which means that even one piece of negative information can put a cloud over a bunch of positives. Just think of the last time you lost some money. Even if the loss was just a mere fraction of your wealth, it probably significantly impacted your happiness level for that day. So such situations can really irrationally impact a stock and make it an extreme bargain.

A good example I like to use of a company that was irrationally oversold is Kapstone Paper and Packaging (NYSE: KS). The company produces corrugated paper, and grows by making acquisitions and integrating those entities into its ecosystem. The issue with such a business strategy is that earnings are seldom linear and when this is in combination with negative sentiment in the corrugated paper market, as was the case in 2015, the stock gets hammered.

Figure 1: Kapstone Paper and Packaging in the last five years. Source: CNN Money.

As it later turned out, KS solved its issues and—thanks to the fact that people are drinking more and more lattes on the go, and online shopping is booming—the corrugated paper sector quickly recovered with higher demand.

The stock price recovered as the costs of integrating the latest acquisition turned into synergies.

Rule #1:

So the first rule when trying to catch a falling knife is to really find out whether the sector weakness is temporary or a structural issue. Temporary issues are often found in growth sectors where oversupply and supply issues are constantly changing places in order to cover for the growing demand creating short term imbalances.

But sometimes the negative news just keeps compounding and the stock price keeps falling and falling. Just think of GoPro (NASDAQ: GPRO). After the IPO, there was huge enthusiasm about the stock and it went above $90.

Figure 2: GPRO stock price since IPO in 2014. Source: CNN Money.

However, since the peak that was reached soon after the IPO, the stock has declined from over $90 to the price as I’m writing this of $9.13. Many investors who tried to catch the bottom in the 90% decline over the past few years have lost money.

There are of course a few psychological explanations for why we like catching falling knives and how we behave around them where GPRO’s story will fit the explanations perfectly. According to Daniel Kahneman, Nobel Prize winner and author of Thinking Fast and Slow, when catching a falling knife, investors tend to take action based on intuition rather than on rational analysis. When a stock price moves quickly, people tend to think fast, which is inherent to our fight or flight mechanism instead of carefully assessing the new information and taking the time to gather enough information to be able to make a rational decision about it.

What often leads to wrong investing decisions is anchoring to the previous price high. In GPRO’s case, many investors anchored their buys to the $90 high assuming GPRO would reach that level again and if you look at GRPO’s chart, the mid-2015 bull run seemed to confirm the bias.

Secondly, investors tend to think their insight is special and their insight gives them an advantage over their peers. In the GPRO case, I think many users of GRPO’s camera attached the same value and quality the camera has to the stock.

Thirdly, and perhaps the most important factor related to falling knives, is that the market is fundamentally unpredictable. We can try to estimate a company’s earnings in the next few quarters, but seeing beyond that and what will be the company’s guidance is extremely difficult.

Going back to GPRO, their last earnings report did actually beat analysts’ estimates greatly, both on the revenue and earnings level, but the guidance kind of disappointed. This led to another unfortunate drop in the share price. which leads to rule number two.

Rule #2:

Before buying a declining stock, first analyze your own behavior. Are you intuitively anchoring the purchase to a past price? Are you allocating extreme value to a not so important piece of the puzzle (quality of GoPro camera)? Are you able to precisely estimate future business and sector fundamentals, or at least better able to than what the rest of the market can? If the answers are yes, or yes and no respectively, look at some other opportunities.

However, what’s interesting is that historically, catching falling knives has been lucrative as the stock market usually overreacts to bad news making buying recent losers a profitable investment. Thaler and DeBondt explained the phenomenon in their 1985 “Does the market overreact?” article. However, their data looks at monthly returns while most bad news usually comes over quarterly periods and earning releases. However, this leads to rule number 3.



Rule #3:

Understand the difference between short term oversold and the long-term trend. It will save you from a lot of disappointments.

The Cliché – Don’t Catch A Falling Knife

Now, if everybody followed the rule of not going near a falling knife, then it would be logical that a stock would quickly become oversold and the stock price move irrational because there will always be sellers on bad news but just a many buyers. Therefore, there must be an opportunity at some point.

From my experience, I would say that the most important thing to do is to carefully analyze the company, take your time by not rushing into a purchase, analyze the sector’s dynamics, look at what analysts and investors are looking at, and try to estimate whether future news will be better or worse than expected.

Rule #4:

Know the company and sector better than anybody else. The investing world isn’t as big as it looks and there are often just a few analysts covering a stock. Put more effort into analyzing the sector than what they are paid to do, and you’ll quickly get ahead of the competition.

Another stock that has looked like a potentially falling knife in the last few years is Under Armour (NYSE: UAA).

The one-time Nike rival has entered into a spiral of bad news and bad sentiment that has really pushed the stock price down. Margins have been declining, and inventories rising while revenue growth has been constantly slowing down.

The only way to pick a bottom in such a situation is to understand the environment better than most anyone else does and estimate earning in a more precise way. This means that you should put more effort into analyzing the company than any analyst, and the sad thing is that many times there won’t ever be a bottom. If that’s the case, buying put options or shorting might pay for the overwhelming research and perhaps even lower the risk if you are wrong.

Rule #5:

Manage your risk carefully and consider buying options to lower the risk and increase the returns.

Your knowledge about the company should give you a pretty good estimation of intrinsic value, but make sure to implement the possible continuation of the negative trend in such a calculation. Because negative news, like declining revenues and declining margins, can quickly lower the intrinsic value you have calculated in the past.

Rule #6:

When calculating your own intrinsic value, try to assume what will happen to the intrinsic value of the stock if the negative trend continues. If the stock currently trades below your worst-case scenario, then it could be a buy.

Another very important thing to understand is that catching a falling knife is a strategy that isn’t linear and therefore when done well, leads to outsized returns. It’s very important to always know that you are fallible and that your estimates might be wrong. The best medicine for that is diversification and learning how to say no.

Rule #7:

Even if your batting average is 50%, your returns should be positive.

Let’s say you buy 10 falling knives. Of those 10, 5 double in the next year, two go nowhere, and 3 go bankrupt. Your return is still 20% which is excellent even if you were right only on 50% of the stocks.

This will also lower your risk and increase the returns as the maximum you can lose is 100% but the upside is unlimited.

Rule #8:

Apply the same analysis principles to a rising stock in order not to sell too soon.

Good news also often compounds, the excitement reaches many investors, and you might get to reap extraordinary returns.

As always, analyze your behavior first and then the stock and the sector. As long as there is a high chance the stock can continue on an upward trend, take advantage of it.



Rule #9:

Learn how to say no. Fortunately, the market has so many stocks and opportunities that learning how to say no in the stock market is of extreme value. You might miss out on some returns, but you’ll miss out on even more losses.

Rule #10:

The final rule is an essential rule for any kind of investment. Look for value and a margin of safety.

When the value for shareholders is higher than the current stock price—even in the case of the worst possible scenario including a recession, CEO, CFO resigning, accounting scandal, or dividend cut—then bet the farm!

The point is that with falling knives, we should dedicate the same amount of time and effort into analyzing our behavior in relation to the situation as much as trying to rationally analyze the situation itself. When knowing oneself and the company that is analyzed, you will increase your batting average which is the most important thing in investing.

© 2017 Investiv