The stock market is filled with all kind of people. Some prefer investing in fast-growing companies while there are others who prefer investing in high dividend-paying stocks. There are also value investor who favors investing in discounted companies. And then comes the daredevil bargain hunters who are eager to invest in falling knife stocks.

In this post, we are going to discuss what exactly are falling knife stocks and why it is dangerous to invest in these type of stocks. We’ll also look into a few strategies that investors can use while trying to catch a falling knife stock.

What are falling knife stocks?

The falling knife is that category of stocks which has undergone a rapid decline in share price in a short amount of time. Here, the term ‘falling knife’ is used as a metaphor for the rapidly declining share price of the company.

Now, by definition, there is so specific ‘magnitude of drop’ or ‘duration’ to define these falling knife stock category. The stock which may fall +50% in a month or +80% in six months, both can be considered in the category of falling knife stocks.

In the investing world, it is always suggested that “Do not try to catch a falling knife!”, especially if you’re a beginner. Anyways, the investors should proceed with great caution if they are interested to invest in these kinds of stocks. In general, these stocks are extremely dangerous and may result in a severe loss if the investor enters at the wrong time.

Note: Even in real-world, trying to catch a falling knife is extremely dangerous and can easily hurt your hand. A thumb rule here is to wait for the knife to fall on the ground and then pick it up. Similarly, if you are planning to invest in a falling knife stock, wait until the prices drop at a significantly lower price with a huge margin of safety.

A few recent examples of falling knife stocks in the Indian market

— Yes Bank: The stocks of Yes Bank has declined over 85% in the time duration between August 2018 to September 2019.

— Manpasan Beverages: The stocks of Manpasand Beverages has declined over 95% in the time duration between May 2018 to September 2019.

— DHFL: The stocks of Deewan Housing Finance Corporate Limited has fallen over 90% in the time duration between September 2018 to September 2019.

If you have already tried catching these falling knives stocks during their downward journey, your portfolio would have been severely hurt by now. However, can these stock rebound and give massive returns to the investor who are planning to enter at this price? The answer to this question requires a lot more comprehensive study than just looking at their share price.

How falling knife stocks work?

The journey of falling knife category stocks is pretty straightforward. Initially, the negative news regarding a company can result in the decline of the share price. However, when the situation continues to degrade, it results in a market panic and subsequent fall in the prices. During such cases, there are two possible outcomes:

• In a few cases, the share prices may rebound if there is positive news or the company is able to control the damage in the near future. Such scenarios can be extremely profitable for the investors who bought the stock at the discounted price before they bounced back.
• However, in most cases, the investors may face severe loss even if they bought the stock at a discounted price if the company’s performance continued to weaken. In the worst-case scenario, if the company goes for bankruptcy, the investors may have to lose most of their investments.

Overall, picking such stocks at the near bottom can result in a massive gain. However, entering these companies at the wrong time may lead to a disaster. There are cases when these stocks never rebounded to the original price for decades since they started falling.

Reasons for the Company’s Price to fall:

There can multiple reasons for the company’s share price to decline. Here are a few of the top reasons:

• A significant decline in revenue and profits for a continued time period.
• Negative reports and the company continuously missing the market estimates/targets.
• Deterioration of the company’s fundamentals
• Discovery of malpractice by the company, fraud charges by SEBI or lawsuits
• Changes in the management like the resignation of top managers, promoters, etc

Here, if the decline in the price is due to temporary reasons, the long term investor should continue to hold the stock or even buy more. However, if the reason is because of the change in the company’s fundamentals, it’s time to exit, even if you have to book a loss.

Also read: Why is a VALUE TRAP? The Bargain Hunter Dilemma!

Why investors are so much interested in catching falling knife stocks?

Many people find investing in falling knife stocks fascinating because of the following reasons:

• As the share price of these companies has fallen significantly, they appear to be undervalued. Most investors consider these stocks as an excellent opportunity to purchase the stock before it rebounds to make handsome capital appreciation.
• People anchor the current price of the company with its original price before it started falling and hence believe them as cheap. However, while anchoring the price, they do not give enough importance to recent events which resulted in the decline of prices.

Anyways, an investor should only buy these stocks if they have fundamental reasons backing the company, not just because the price has fallen significantly.

Also read: 11 Must-Know Catalysts That Can Move The Share Price.

A few points to consider which catching a falling knife stock:

If you are planning to invest in a falling knife stock category, here are a few points that may help you to analyze the situation better and avoid loss:

— Start with analyzing your own behavior: Are you planning to enter that stock because you’re anchoring its current price with its past prices, based on some predictions, or just to gamble.

— Say ‘no’ more often: In most of the falling knife cases, the stock is not profitable to the investors for sustained longer period of time. Although such stocks may seem like a great opportunity, try to say ‘no’ to the stock as much as possible. The more frequently you say ‘no’, the more time you’ll get to study the company and evaluate it better.

— Understand the situation: Read about the recent and past happenings and analyze whether the problem is temporary or structural.

— Do not buy stock on the first decline: There’s a famous Cockroach theory which says that if you find one cockroach in your kitchen, there are more cockroaches likely to be discovered. Similarly, if there’s a piece of bad news related to the company, more is yet to be revealed. Usually, after the first decline, there are more troubles ahead for the company. Therefore, as a thumb rule, do not jump into the stock on the first decline.

— Know the worst-case: Knowing the worst-case scenario can make you prepare for it. Before entering the stock, know how much risk can you handle. Will you be comfortable if your investment value in that stock falls below 70%? What is the risk vs reward for your investment?

— Be pessimistic: While calculating the intrinsic value of the stock, always be pessimistic and take conservative values while estimating the growth rate and estimating the future cash-flows.

— Always have a margin of safety: As these stocks have a higher risk, always have a bigger margin of safety while investing in these companies. For example, if the fair calculated intrinsic value turns out Rs 100, then give yourself a margin of safety of 40% and invest only when the price goes below Rs 60. The higher the margin of safety, the lower will be the risk.

— Diversify — Yes, you want to make big returns and the falling knife stocks seem to have the potential to give higher capital appreciation. However, if because of any reason, let’s say that your study is wrong or the stock didn’t perform the way you supposed it is going to, then you will face critical damage. Therefore, do not put all your money in a single stock, but diversify.

Also read: 5 Psychology Traps that Investors Need to Avoid

Closing Thoughts:

A falling knife stock category may represent a high opportunity, but they also have a higher potential to hurt the investor’s portfolio.

For newbie’s, it’s difficult to judge whether the stock is a value stock or value trap. If you are a beginner and not experienced in judging companies, I would suggest to simply ignore these stocks and try to find fundamentally strong companies.

For experienced investors, if you are planning to purchase them, then know what you’re getting into. Analyze the reward that you may receive by investing in these stocks, but also have the heart to see your investments going down and not making any gains for a long time. You should not expect the stock to bounce bank the very next day or even a month or so when you enter.

Kritesh Abhishek

Kritesh (Tweet here) is the Founder & CEO of Trade Brains & FinGrad. He is an NSE Certified Equity Fundamental Analyst with +7 Years of Experience in Share Market Investing. Kritesh frequently writes about Share Market Investing and IPOs and publishes his personal insights on the market.