Share price bargains? How to avoid catching falling knives

Sometimes a falling share price can offer opportunity. This is where the idea of value investing comes in – picking shares that trade on a valuation that doesn’t reflect what the shares are really worth.

While holding onto these shares can be beneficial over the long-term, finding good quality low-valued stocks is notoriously difficult. Even legendary value investor Warren Buffet hasn’t got it right every time.

Often in situations where a share price falls sharply, investors jump to try and catch what they view to be a bargain. But there’s a big difference between rock bottom prices and good value.

An investment concept known as momentum comes in here too. Decades of investing history have shown that, on average, companies that have done well and outperformed the market are more likely to continue to thrive, though there are no guarantees. At the same time those that have struggled have tended to continue to underperform.

One of the biggest mistakes investors make is thinking if a share price has fallen dramatically, it can’t fall much further. Thinking this way oversimplifies the issue. In fact, a share price that’s fallen as much as 90% could still halve – and then some.

All investments carry an element of risk, and it’s important to remember that share prices can fall as well as rise in value, and you could get back less than you invest.

“You’re only saving money if you’d have bought it anyway”

This is a saying about people that splash their cash on sale items. It’s pretty accurate.

The same logic should apply to buying shares. If you’re trying to jump in on a depressed share price because it must be a “bargain” if it’s fallen so much from its peak, think again. You could be wasting your money.

Take Carillion. This now infamous example of a “falling knife” share price holds some lessons.

Investors could have looked at the share price at the end of October 2017 and noted it had fallen over 75% in around four months.

Carillion share price July - October 2017

Source: Thomas Reuters datastream, ran to 31 October 2017.

Looking at that drop in price could have convinced you to invest, because “what’s the worst that can happen from here”? The classic, too-cheap-to-be-a-bad-decision trope.

It could get worse

Investors that decided to buy Carillion at the end of October would have seen their investment fall 63.2% by the end of November. That’s a lot more than the 25% you might have expected on the surface of things when you’d looked at the 75% dip when you decided to invest.

Carillion share price end of October - November 2017

Source: Thomas Reuters datastream, ran to 30 November 2017.

You know the ending, but remember the lesson

We all know where the Carillion share price went from here. After drifting further, the shares were suspended on 15 January 2018 and investors’ holdings became worthless.

What we’re saying might seem like basic maths, but it’s easy to get swept up in a falling share price. A bit like if that jacket you think you want was put on sale, and you buy it just because you’re worried the price will go back up.

If you didn’t really need, or even like the jacket that much, but buy it because of the price tag, all you’ve really done is waste your money.

Carillion share price in the final weeks of trading

Source: Thomas Reuters datastream, ran to 15 January 2018.

This is of course an extreme example, and the fate won’t be the same for every struggling share price.

But, particularly at the moment, with conditions so tough and volatile, investors need to be vigilant. If you see a share price falling dramatically, there’s often a reason why. And in many cases, there’s further for your investment to fall than you might initially think.

This article is not personal advice. If you’re not sure if an investment is right for you, please seek advice.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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