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Source: https://the7circles.uk/8♠-dont-catch-a-falling-knife/
Don’t catch a falling knife – stocks that have dropped in price usually keep falling
Today I’m going to try to persuade you not to catch a falling knife.
Inexperienced investors often think that the fall in price means that they are getting a bargain, and that
the stock will soon recover to its former price.
But it won’t.
Stocks fall for a reason, and whatever the reason is, the stock is no longer worth what it once was.
Daniel Kahneman looked at why people think that they can predict the market’s turning points in his
book Thinking, Fast and Slow.
we all believe that we have special insights that give us an advantage over other people (in the same
way that we all think that we are good drivers)
when things change quickly (such as a rapid drop in the price of a share or a market), we use our “fast”
thinking system – our intuitions, the fight or flight response
we’d be better off slowing down and analyzing why the price is falling
despite plenty of evidence that the market is unpredictable, the entire finance industry attempts to
persuade us that we can outperform by buying an active fund
the massive marketing budgets of the asset managers confuse us
We ought to make a distinction at this point between catching a falling knife and the process of value
investing.
Value investors had a clear idea of what a stock should be worth – it’s “intrinsic value”.
There may be better bargains around, or at least bargains that are likely to rise in price sooner.
Stockopedia recently did a study on profit warnings, which we covered here.
A profit warning is basically an announcement from a company that their next set of results won’t be as
favourable as the analysts are predicting.
Their profits will be below the consensus estimate or “market expectations”.
Naturally, the stock price is likely to fall on this news.
What Stockopedia looked at was whether it’s worth holding or even buying the stock after that fall in
price.
Or to put it another way: should you catch a falling knife?
Lots of people think that it’s generally a good time to buy after a profit warning.
These stocks continued to fall, under-performing a gently rising market for the next 350 trading days
(almost 18 months).
There was on average no “bounce” or recovery.
(( Interestingly, they also underperformed the market during the 100+ days (around six months) before
the PW – this implies insider trading or leaking of information, or possibly sector pressures reflected in
warnings from other firms ))
Stockopedia sell data on stocks, based around the concept of Stock Ranks for Quality, Value and
Momentum.
They found that stocks with high Quality and / or Value scores were more likely to announce PWs.
But high Quality stocks were more likely to recover after a profit warning.
Those with good Momentum scores (whose share prices have been rising) were less likely to have a
profit warning.
(( This is to be expected since Stockopedia found that stocks with profit warnings had been
underperforming the market in the previous six months. Defensive stocks are also less likely to issue a
profit warning when compared to cyclicals ))
When there were fewer than 20 stocks for a portfolio, the performance was taken as zero.
Although there were some periods of outperformance (what Lapthorne called the “dash to trash”), all of
the portfolios eventually underperformed the market.
Stocks that had fallen the most generally underperformed the most.
Performance declined from one month through to nine-month holding periods, improving slightly
(though remaining negative) for a 1 year holding period.
Although underperformance was lower (for example, -5% over nine months, rather than -7%), it was
still present.
And the pattern of deteriorating performance from a one month to a nine-month holding period,
followed by a slight improvement to twelve months was also repeated.
Lapthorne did find one exception to the rule.
When the whole market is cheap (as measured by the percentage of “beaten-down” stocks within the
market), then buying the falling knives does work.
But the same result was found if valuation measures such as PE was used instead of the fall in share
price.
So it seems than in a cheap market, buying falling knives correlates closely with buying value stocks.
So remember, unless the whole market is cheap:1Don’t catch a falling knife – stocks that have dropped
in price usually keep falling.