Business, Legal & Accounting Glossary
A falling knife is a stock that has dropped dramatically in price over a short period of time.
Falling knives can be quite a trap for investors, the temptation is to buy the stock because it looks cheap now. But stocks don’t always go back up and just because it’s cheap now doesn’t mean the stock can’t get cheaper still. Unfortunately with falling knives, that’s often the case. Many a careless investor has a bought a falling knife of a company that is cheap but still overvalued or a company that has weak business prospects.
If an investor wishes to try to catch a falling knife he or she should keep in mind four things
Buying when a stock is plummeting takes guts, but it can be exceptionally profitable when it works out.
There’s money to be made from catching falling knives. The challenge is doing it without losing a finger.
The first rule of catching falling knives is that accuracy is more important than quickness. Stocks fall because of bad news. That bad news will typically take some time to absorb, so you usually have time to evaluate the investment. And this is one time you shouldn’t rush — it’s important to understand how the news will have an impact on the outlook of the company.
Is it just a one-time event that nobody will remember in a year, or does it affect the business more substantially? Is the company’s competitive position affected? Or, even worse, is its liquidity? You should be looking to catch knives that result in shares being cheap, but don’t substantially affect a company’s long-term outlook.
An ideal knife to catch would have been Merck (NYSE: MRK) below $30 back in October 2005 at the peak of the Vioxx uproar. Merck’s competitive advantage was in its ability to create, acquire, and commercialize drugs, and this advantage was unlikely to be affected by Vioxx. Its balance sheet was solid, with $10 billion in cash. Vioxx was bad, but clearly not a company-killer, and now the stock is above $50.
When you’re catching knives, prepare for the worst. Often, a stock will continue falling after you buy it. You should plan for this scenario. One way of doing this is by dividing your money into three piles and buying in thirds. Buy the first third at a good price. If the stock continues to fall, buy the next third. If it drops once more — and the stock seems more attractive than ever — buy the final third.
My rule of thumb is to buy a big enough initial position that I’m content if the stock recovers, but a small enough position that I’m even happier if it goes down and I can buy more at a cheaper price.
The final rule of falling knives is to be certain that the stock is cheap based on your analysis of the company’s potential. Even if a stock has fallen by 70%, that doesn’t make it a good buy. Historical prices have little to do with whether a stock is fairly valued right now. If a company is 300% overvalued, then even if it falls by 50%, it’s still overvalued by 100%. So, before investing, make sure you calculate the company’s fair value based on your current outlook and only buy if the stock is cheap.
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This glossary post was last updated: 5th August, 2021 | 0 Views.