Never try to Catch a Falling Knife

Most investors tend to believe that any correction in a stock is an opportunity to buy. That is like trying to catch the proverbial falling knife. Every correction in stock price does not make it attractive. More often than not, sharp corrections are a result of key technical and fundamental shortcomings. Jumping in and buying such stocks will be foolhardy. The key is to spot and avoid falling knives!

FROM THE EDITOR’S DESK

Back in 2010-11, when the stock price of Kingfisher was falling rapidly, many investors were wondering if it was a golden opportunity to buy the stock. It was still a classy airline, part of a profitable group and had clear market share. But things had begun to change. Debt was too high, cash was crunched and the company was hurtling towards operating un-viability.

Over the last 5 years, Kingfisher has not been an isolated case. Companies like RCOM, Deccan Chronicle, Unitech, DLF, Suzlon and the Jaypee group have seen substantial value erosion of 80-90%. While other business models may not be unviable like Kingfisher, the problems of debt are huge. That would make any bounce-back very difficult. Never try to catch such falling knives!

Falling knives are also common among the large cap names with highly reputed managements. This typically happens when a major cycle reverses or pricing power is suddenly lost. Larsen & Toubro between 2010 and 2013 was a falling knife due to a slowdown in the capital cycle. HUL was a falling knife between 2003 and 2006, as it lost pricing power to competitors.

3 TRIGGERS OF THE FALLING KNIFE SYNDROME

The Macro trigger for a falling knife

We saw this phenomenon in 2008 after the sub-prime crisis. In this case, most stocks became falling knives as financial bankruptcies forced sell-offs across markets. Such markets are best avoided, irrespective of apparent value!

The Industry level triggers

These cases are visible in good and bad markets. Tech stocks in 2000 and Real Estate stocks in 2008 were pronounced falling knives. Metal companies became falling knives when the global commodity cycle turned downwards!

The company specific triggers

These have nothing to do with macros or sectors. Satyam in 2009, Kingfisher in 2011 and Financial Technologies in 2013 are extremely stock specific cases. They became falling knives purely due to their internal company-specific problems.

“Don’t ever try to catch a falling knife unless and until you have a perfect handle over the risk involved” – Warren Buffet

6 SIGNS THAT A STOCK COULD BE A FALLING KNIFE

  1.  More often than not you are able to identify a falling knife only after you see it falling. One of the first indicators of a falling knife is visible in a shift in ownership. Normally, promoters and global institutions are the first to smell a rat and exit. If you find this happen for 2 quarters, it is a potential falling knife!
  2. Watch out for debt and the debt coverage ratios. Companies with huge debt books are especially vulnerable to becoming a falling knife. Most of the falling knives in the recent past have been outcomes of too much debt. The problem with high debt is that it simply gets compounded!
  3. Watch out for the forex exposure of the business. This is true for companies which have a heavy import content as also for companies that have huge foreign currency borrowings. You normally do not have control over the currency. An unhedged foreign currency can create a falling knife!
  4. Is the industry in which the company operating undergoing a subtle shift? Look at the way online selling is putting pressure on brick and mortar retail. Look at the way online banking put pressure on branch banking and mobile telephony put pressure on fixed telephony. They created falling knives!
  5. Lack of transparency is something everyone needs to watch out for. Unexplained transactions, too many group companies, too many inter-group transactions, absence of Chinese walls should all be red flags. The Financial Technologies group was a classic example where opacity was a red flag.
  6. Finally, watch out for the technicals. Is the stock consistently breaking DMA supports? Is it creating new lows regularly? Has the stock suddenly become extremely volatile. Do you see accumulation in deep OTM put options? Is the selling pressure on the screen consistently high? These are typical falling knives!

WHAT IF YOU MISS OUT ON AN OPPORTUNITY?

That is perfectly possible. A few things that investors need to remember. A stock or an index rarely shows a V-shaped recovery after a sharp fall. Normally the price stabilizes, then the volatility stabilizes and finally pessimism begins to peak. That is the point when the stock could become an opportunity. Of course, this is subject to the fact that the company has not seen permanent damage to its value proposition. Don’t ever catch that knife.

The key problem with trying to catch a falling knife is that you are damned if you don’t and absolutely damned if you do. As Warren Buffet himself explains, “Instead of jumping in to catch a falling knife, wait for the knife to fall and then pick it up from the ground.” The moral of the story is very clear. When you avoid catching a falling knife, you may lose out participating in a bounce-back opportunity. But at the end of the day, buying a dead-cat bounce was never worth the risk!

TAKEAWAYS FROM THE “CATCH A FALLING KNIFE” DEBATE…

What are the takeaways for your investment strategy? First and foremost, when you try to catch a falling knife, the likely risk far outweighs the unlikely returns. Secondly, in most cases it is very difficult to differentiate between falling knives and value candidates. So if the above indications are there, then better safe than sorry. Finally, any falling stock is accompanies by hordes of short sellers. As they cover their positions, there will be bounce-backs. You surely do not want to believe that, right?

Whether you are a short term trader or a long term investor, it always pays to be with the winning stocks and winning sectors. Catching a falling knife goes against the basic grain of prudent investing. At a price of Rs.3/-, many investors told me that if they bought Kingfisher at that price, their maximum loss would only be Rs. 3/- My answer is that if you really want to lose Rs.3/- there are better, more enjoyable ways to lose the money. If you think about it, you will not try to catch a falling knife.

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