How to catch a falling knife

The market is full of colourful phrases.

One example is ‘dead cat bounce’ – when a stock price collapses and then briefly bounces before collapsing again. 

Another is ‘trying to catch falling knives’. 

This is when we frantically buy the same collapsing stock in the hope that we are buying at the bottom. 

Usually, however, we get it wrong and lose our fingers in the process.

I’ve been reminded of these phrases recently as my inbox fills with questions about some of our fallen angels, with readers specifically asking whether it is time to buy them. 

I’ve also been reminded of a comment from a friend who now  runs IG Australia. 

This friend of mine is always full of insightful ideas that aren’t (but should be) market phrases. 

One of my favourites is that a ten-bagger first needs to be a one-bagger before it goes on to become a ten-bagger. 

We should therefore be patient.

A ten-bagger is a stock that goes up tenfold, or by 1 000%, and is one of the holy grails of investing as they’re fairly infrequent occurrences. 

But, in the pursuit of these ten-baggers, investors often buy far too soon and instead of catching the bottom of the collapse they end up buying into a falling stock. 

Such a mistake can be deeply painful to your portfolio. 

Think Aspen. 

At R300 per share, and again at R240, many suggested it looked like great value. 

At R140 the experts were certain it was great value. 

Yet, now it’s at around R100 after hitting R70 when the results were released in March. 

Trying to catch that collapse would have been very costly.

My friend’s idea is to wait for the stock to first double in value – the first ‘bag’ – before buying. 

If it truly is going to the moon and going to be a ten-bagger (or more), waiting for the first doubling of the share price will significantly reduce risk. 

A recent example has been Kumba Iron Ore. 

When the resource stocks were being aggressively sold off, I suggested waiting for them to eventually double in value before buying. 

With Kumba at a low of around R25, that meant an entry of some R50. With the share now above R430 that waiting certainly paid off for the patient investor. 

But many others tried entering on the way down at R300, R200 or R100 and now have reduced profits as a result of poor entries. 

Trying to catch a falling knife (and missing) means either you’ll give up and exit at a loss or, when it does turn, you’ll have that much higher entry.

One concern many have about    waiting for the first ‘bagger’ before entering is that you reduce your potential upside. 

Yes, of course you do. Buying Kumba at R25 would have returned a much better profit than waiting for the R50-entry. 

Yes, your profit is less. But markets are about managing risk. 

And trying to catch that knife almost certainly means you would have been buying on the way down as you are trying to catch the bottom and losing money all the time, until eventually it turned. 

So truthfully, waiting for the R50-entry would likely have made better profits than trying to catch the knife at the bottom and repeatedly missing.

Looking at the current market, there are a lot of fallen angels that I am being asked about, with share prices down by way more than just 50%. 

We have some darlings that have lost more than 70% in value, and in some cases even 90%. 

Everybody keeps asking when these shares are ready for buying. 

The answer is easy: Use my friend’s advice and wait for the share to double in price off the lows. 

Then you have an entry with momentum that probably won’t be a dead cat, nor will your fingers be in danger.

This article originally appeared in the 9 May edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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