How to Catch a Falling Knife

The expression “catch a falling knife” refers to buying stocks or bonds which have fallen significantly in price, with the hope that they will soon return to their former price. If done well, the buyer nets a handsome profit in a short period of time. The differences between “catching a falling knife” and normal investing are the time frame, the research that goes into the decision, and whether an investor believes that the market is efficient in setting the correct price for a security.

To understand the basic difference between “falling knife” investors and long-term investors, we need to remember that the price of a stock is based on the profit investors expect a company to make. All things being equal, a stock’s price goes up when the outlook for the company’s future profits goes up, and down when the outlook for future profits is not as rosy.

The falling knife investor is driven by the lure of quick profits. He has a short time frame in mind, usually about a year. This investor believes that the market’s perception of a company (reflected in the company’s stock price) is out of line with reality. This investor believes that research experts have overlooked some significant facts that will cause the security to appreciate again fairly soon. More importantly, this investor believes that other investors have overreacted to whatever information made the stock price go down. Finally, this investor believes that the bad news is temporary, and it will not have a lasting effect on the company’s finances nor the stock’s price. In short, the falling knife investor believes that the market price for this security is wrong.

Long-term investors believe differently. They believe that the market is usually “efficient” in that it assigns an appropriate price to the security based on relevant, known information. They reason that, while short-term market “inefficiencies” might exist from time to time, there is no way of distinguishing price movements resulting from random market inefficiencies from movements based on longer-term price trends. Accordingly, they believe that stocks are fairly valued most of the time.

Long-term investors are motivated to act based on research published on the company by independent sources. They want to understand the business and investment risks. Falling knife investors don’t do much research on the company’s actual financial situation or profit outlook.

The difference in philosophies came to mind this summer when one of our clients asked me for an opinion about Fannie Mae and Freddie Mac. The stock prices of these two highly respected companies have plummeted by about 90 percent in the past year, as their financial strength unraveled in the wake of the mortgage crisis. Our client asked me if the market was overreacting, and whether Fannie and Freddie were poised for a quick rebound. In other words, our client was looking for a chance to catch a falling knife.

I explained that BWFA’s investment approach did not focus on identifying market inefficiencies .We look at long-term fundamentals, and we don’t try to judge when the market has wildly misjudged a company. Were BWFA to buy Fannie and Freddie on behalf of our clients, it would be because the companies were sensible investments on their merits, rather than because we thought that market sentiment about them would turn around as strongly in their favor as it turned against them in the last year.

Everyone would like to make quick profits by investing in companies that have been overly punished by the market. However, the evidence shows that the market is mostly accurate in determining prices, and betting against it is usually not a profitable strategy.

At BWFA, we maintain a disciplined, structured approach to investments with a longer-term focus on quality companies.

Editor’s Note: Two weeks after this article was written, Fannie Mae and Freddie Mac were both taken over by the US Government. Stockholders of both organizations will probably lose the remaining value of their investments.