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Three rules for catching falling knives

| Equity Analyst | 14 November 2017 | A A A
Three rules for catching falling knives

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Buying shares in companies that have seen dramatic falls in share price is a popular, if high risk, trading strategy.

Sometimes described as “catching a falling knife”, a large share price fall today doesn’t rule out another tomorrow. Consider a share that falls in value by 90%. At some point it was down 80% (i.e. it was worth 20% of the starting value), and has since halved again to be worth just 10%.

However, catching knives can be very lucrative, if done for the right reasons with an understanding of the risks. That’s particularly true when the market is nervous. Investors never take profit warnings well, but companies missing expectations at the moment seem to be being particularly harshly punished.

There is no foolproof way to reach for a falling knife. But we do have some tips that will hopefully reduce your chances of getting your fingers burnt (or cut).

1) Always read the update

It sounds obvious, but it’s surprising how often investors can get sucked into double digit share price falls without looking at why the shares have fallen.

A lower share price doesn’t necessarily mean a share is cheaper. If profit expectations have halved, then a company’s shares might be more expensive today than they were yesterday, even after a 40% drop in the price. Tempting though it is, don’t confuse the price of a share with its value.

Of course knowing exactly what future profits are going to be is difficult even for professional analysts. So we tend to apply a quick common sense test to large share price falls.

We ask ourselves; has something about the market, or the business, fundamentally changed for the worse? If the answer’s yes, then it’s likely the company will continue to struggle in the medium term, and while the shares might be oversold, until things settle down it’s very difficult to tell what an appropriate price will be. In these situations we feel it’s not worth the risk of reaching for the knife.

However, share price falls will often be triggered by short term, one off headwinds. In these cases you would expect the company to get back on an even footing pretty soon (all things considered). That can mean it’s worth taking a closer look.

2) Avoid debt

An over-indebted business is a worry at any time, but when profit warnings hit and the share price starts to fall, debt is a source of particular concern. A company whose debt has got out of control at the same time as profits are falling can face a whole catalogue of horrors.

Investment in the business dries up, since spare cash is diminishing and what remains is tied up servicing debt. Lenders will likely be reluctant to extend new credit lines. With sources of cash dwindling, companies find it difficult to address the long term problems that got them there to begin with.

To free up cash, companies may cut the dividend or sell-off prime assets. In a worst case scenario the company may have to issue new shares to repay the debt. Existing shareholders will see their share of the business diluted, and at a lower price to boot.

A useful number for those concerned about excessive borrowing is the net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio. This number essentially tells investors how many years’ worth of cash generation it would take to pay off the current level of debt.

While there is no hard and fast rule for how much debt a business should carry, in general more cyclical businesses should aim for a lower net debt to EBITDA ratio. Comparing companies with other similar businesses can provide a useful insight.

3) Be clear on why you're buying stock

It’s possible to use dramatic falls to pick up companies with great long-term growth prospects, stellar intellectual property or market-leading assets. But make sure you're clear in your own mind as to why you're investing in the share.

For businesses going through tough times, things can change quickly. Conditions might well get worse before they get better, and if the company’s fortunes continue to wane it can morph in to something very different. Companies that have posted dramatic profit warnings often undergo wide ranging strategic reviews, and management changes at the top are not uncommon.

If you buy shares after a sharp price fall, it’s important to keep tabs on any news flow out of the business. Being clear on why you are invested in the business makes deciding on whether to continue supporting the business easier.

The message here is that while buying a distressed share is potentially rewarding, it’s also a higher risk approach and requires investors to pay more attention than more conventional investing.

This article is not personal advice. All investments can fall as well as rise in value. If you are unsure of the suitability of an investment for your circumstances seek advice.