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The dangers of trying to catch a falling knife

Sophie Lund-Yates, Equity Analyst, explores why investors should be very wary of companies with sharply falling share prices by exploring some recent high profile examples.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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.

Over the long-term, holding onto these shares can see shareholders benefit, but 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 a lot more likely to continue to thrive. At the same time those that have struggled tend to continue to underperform.

There have been some recent high profile examples of why trying to catch a falling share price is a dangerous strategy, and shareholders have seen their investments fall to, or close to, nothing. While it’s sometimes impossible to know if a company is going to fail, and there’s always an element of hindsight in these situations, there are lessons to be learned from the recent downfalls of Wirecard and Intu.

All investments carry an element of risk, and it’s important to remember that share prices can fall as well as rise, and you could get back less than you invest. This article is not personal advice. If you’re not sure if an investment is right for you, please seek advice.

Wirecard – don’t let the past distract you

There’s an analogy we often use on the share research team, which likens investing to buying a car. If a car has a seriously knocked-down price, a buyer’s initial reaction is usually, and often correctly, “what’s wrong with it”?

That’s something investors in Wirecard have been forced to recognise. The group entered insolvency proceedings at the end of June after it was discovered that €2bn of cash on the balance sheet simply didn’t exist. Albeit at the time of writing its shares are still trading following a short suspension. Corporate fraud is hard to see coming, but there’s still a lesson to be learned here. And it comes down to that all important question of value.

Wirecard was once a European tech darling, calling itself “one of the world’s fastest-growing digital platforms for financial commerce” no less. Its services focused on electronic payment processing and payment solutions.

So rapid was the group’s ascent that revenues (apparently) more than tripled between 2014 and 2018, reaching EUR2bn. Crucially, at the same time as revenues and profits seemed to be swelling, its valuation grew at a heady pace too.

At its peak Wirecard shares were changing hands for around 55 times expected earnings, much higher than its average. High valuations signal confidence from the market about the future, but they also come with high expectations. It means any disappointments or changes to estimates can be very hard on the share price.

Reported revenue

Past performance is not a guide to the future. Source: Wirecard annual results

Please note that 2019’s revenue figures have been withdrawn by Wirecard and therefore haven’t been included.

The other potential risk of historically sky-high share prices is it lulls investors into a false sense of security during the bad times. When news broke that Wirecard was in trouble and the share price plummeted, some will have viewed it as an opportunity to buy shares in a company they believed was likely to recover. Or at least safe from getting worse, simply because of what it was once worth.

The group had already seen its share price fall heavily before this shock too, as it batted away probes into its accounting practices – a good reason to stop and think carefully about the prospects of a company before investing.

A classic misconception is that once a stock has dropped, say, 80%, it can’t fall much further. This isn’t true. If a share price has fallen this much to £10, you could invest £100 at this point. Problem is there’s nothing to stop the share price from dropping another 50% to £5, at which point you’ll have lost half your money. This is a pattern that can continue all the way to a share price reaching £0.

This is a classic “falling knife” scenario. In these moments investors aren’t thinking about the true value of an investment. A look at the accusations swirling around less than perfect accounting practices, and the fact the former CEO had been arrested would’ve suggested this was no longer a company with strong prospects of recovery – despite the success it had once enjoyed.

Things to remember: A low price doesn’t always signal good value. It’s important to understand the difference and take stock of what’s going on with a company when the share price dives, even if it was once seen as a market favourite.

Read more on why investors should be wary of bargain valuations in the current environment.

Intu – listen when something’s out of tune

Familiarity breeds over-confidence. This is a trap we can all fall into both inside and outside the world of investing. Nonetheless it’s an important one to avoid.

Intu entered administration at the end of June, and the shares have now been suspended. That means investors are unlikely to get any of their money back. Many investors that put money in while the share price was falling will have done so believing a company that owns blockbuster assets like The Trafford Centre couldn’t possibly fail.

This is why it’s important to focus on the whole picture and not get swept away by the good bits. In reality Intu was at the epicentre of the rapidly changing retail sector, and its top-heavy exposure to retail tenants and assets meant it was vulnerable. In 2019 increased numbers of its tenants going bust and/or struggling to boost their footfalls meant the valuation of Intu’s overall assets fell 23%. Rental income fell by over 9% and these factors contributed to an eye watering loss of £2bn for the year.

By this time debt was already mounting and “fixing the balance sheet” was the unofficial strapline of the 2019 annual report.

Net debt (cash and cash equivalents minus debts) was at an uncomfortable £4.5bn last year. It’s not unheard of for companies to carry too much debt, but in Intu’s case this was a real red flag. It meant turning its fortunes around became a matter of necessity, rather than a hope for the future, and there was little to no breathing room for things to go wrong.

The group had been struggling in recent years to shrink debt as quickly as profits were falling. This isn’t a hard and fast rule for looking at debt levels, but it’s one way to understand if a company’s debt pile could become problematic. Receding profits make paying interest payments on borrowings more difficult.

Percentage growth in operating profit compared to net debt

Source: Intu final results

Before its collapse, one of the biggest share price falls came after Intu was forced to abandon emergency plans to raise £1bn, because there wasn’t enough interest from investors. Lack of confidence on this level was a real signal times were tough, and that things had the potential to get worse.

Things to remember: Intu is a real example of why it’s important to take a look at the big picture. Knowing that Intu had assets like the Trafford Centre or Essex’s Lakeside will have been seen as somewhat of a security blanket to those investing towards the end. The reality of what was going on under the hood however was a lot more complicated.

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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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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