You have certainly heard this expression a few times in your life as it can be applied to many different circumstances. Yesterday, when I went long on Research in Motion (RIMM) that could be a good description of what I did. Not only has Research in Motion been a poor performer throughout the year but it had its worst performance in a long time on Friday losing almost 11%. I argued that the market had it wrong and that the stock could not go much lower. Many others are saying the same about British Petroleum (BP), the oil giant. Of course the circumstances are very different. So the question here would be: “When is it a good idea to catch a falling knife?“. Many would say never. I would argue that sometimes it can work.
What is a falling knife stock?
Before going further, it is probably a good idea to establish which stock would qualify. My two main rules would be:
-losing value quickly ( 20% within less than 6 months)
-underperforming the market significantly (loss at least twice that of the market – this one is to avoid considering the whole market during market crashes)
Short or long term
Just to clarify, I am talking about longer term declines. The game of buying assets in times of short time crashes such as the one of a few weeks ago is a whole other game and is much more like playing poker than investing in the markets if you ask me.
Hoping for a recovery
Why would an investor do such a dangerous trade? Simple. They hope for a major recovery. When stocks get crushed, and analysts downgrade them (causing further declines), the movement can become irrational and go much further than is logical. That is when smart investors can get huge bargains that are impossible to find in other circumstances. The returns can even be over 100% in a rather short period of time in certain circumstances.
When a certain stock starts to get beaten up, it can become very difficult to reverse the tendancy. Why? First off, technical traders are likely to see triggers reached that will become sell signals. Indicators such as moving averages and other momentum indicators will clearly signal that the stock’s general direction is downward which triggers more losses. That of course will cause more triggers to be breached, etc.
As well, the general psychological impact is important. When the evening news discuss the decline of a companu like Research in Motion, they will explain it by stating everything that is not going well at the company. Now put yourself in the mind of a friend or family member and you can imagine why they are likely to think that more decline will come. As that happens, many longer term investors are likely to sell putting even more pressure on the stock.
It will go against you at first
An important point to remember when buying a stock like RIMM is that it is likely to go against you at first. Why? Because if it’s been declining for months, what are the odds that you picked the exact date where a reversal takes place? Slim to none! So you should expect the position to initally go against you and it’s better to know in advance how much of a loss you can sustain. Setting a stop loss limit will keep you disciplined. It would be too easy to remain in the trade all the way to 0$ by convincing yourself that a reversal is upcoming.
Is the company worthless ?
I think it is a fundamental question to ask yourself. When a company’s stock is diving, it is usually for one of two reasons. Either growth has slowed much more than anticipated or the company’s survival is in jeopardy. In that case, you must realize that there remains a lot of downside. While BP might jump back up and get back to tens of billions in annual profits, I don’t think anyone could argue that bankruptcy is a short term possibility. No matter how optimistic you are about its future, it is impossible to deny the possibility that the US government could take down BP. I would say that Research in Motion is in a very different situation. It is generating lots of profits and in the short to medium term, that will not change so the downside is a lot more limited.
When it turns ok: Priceline (PCLN) : BusinessWeek recently revealed that Priceline was the top performer in the S&P500 in recent years and if you look at the chart you will see that Priceline looked very bad about 5 years ago but someone who purchased near those lows has been a big winner.
When it doesn’t: Nortel (NT) : Nortel was once a telecoms giant but was not smart with its resources and is now in bankruptcy with no hopes of ever coming back….
So the big question is does Research In Motion have potential to turn things around? Honestly, I do think it does have that ability and potential. RIMM has the leading position for all corporate accounts and remains in the race for personal phones as well (even though like everyone else, it trails Apple badly). I don’t think anyone expects RIMM to go down anytime soon so i consider that there is very limited downside from this point on.
How about you, would try catching a falling knife? Or have you already?