When To Buy A Falling Car?

They have been falling like dominoes. Or should it be that they have been falling like cars.

During the financial crisis of 2008, it was banks and other financial institutions that came under the hammer. Then came the turn for anything connected with commodities that were sent to the doghouse. But now it is pharmaceuticals and, more recently, shares in carmakers that have been pummelled.

These are not your fly-by-night speculative small caps. Instead, they are venerable large caps. It goes to show that there is no such thing as a can’t-miss blue chip.

Banks recovered

But bank stocks recovered. Whilst they are nowhere near their highs before the financial crisis, they have, nevertheless, stage a remarkable comeback.

Shares in DBS Group (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39) and United Overseas Bank (SGX: U11) are worth twice as much now compared to seven years ago.

Insurers have recovered too. Great Eastern (SGX: G07) shares, which were changing hands at around S$8 in 2009, are now worth around S$20.

The recovery in financial shares could go some way to prove the point that big winners could be found when an industry is surrounded by doom and gloom.

Some people might even go so far as to say that catching a falling knife could pay huge dividends. In the stock market, a falling knife is a share whose price has dropped severely and, often, quite quickly.

Double-edged problem

The term is said to originate from the stock market saying “Never try to catch a falling knife.” The implication is that the shares might be falling for a reason.

What’s more they could continue to fall. So, by inference, we should avoid picking up the share (or a knife) until it is safely resting on the floor. Or better still, never at all.

However, research from Brandes Institute could suggest that we shouldn’t dismiss falling knives, entirely.

It found that between 1986 and 2002, falling knives posted a higher bankrupt rate over the three-year period following their initial drop. But some falling knives also outperformed the overall market by a wide margin.

Their conclusion was that investors who never catch falling knives could be foregoing significant opportunities. But it pays to be careful. Long shots can miss their mark, spectacularly.

The key, or rather the two keys, are being able to recognise a superior business and being able to correctly decide whether the share price has been depressed below the true worth or intrinsic value of the business.

Comeback kid

The general rule for looking for companies in a troubled industry is to look for those that have staying power. It might also help to wait for the industry to show some signs of recovery.

Some industries just never manage to come back, though, because they have been replaced by superior products. Does anyone need a valve for a TV, anymore?

So, it is important to be able predict a company’s future. If the future cannot be predicted, then the company cannot be valued, either.

But it is the issue of solvency that should dominate our investing decisions. Or put another way, companies that have no debt can’t go bankrupt. They may not recover fully, but if the company can stage a turnaround, then money could be made.

Hit and miss

Picking up the occasional falling knife can feel like a hit-and-miss exercise. But it is important to determine if the price drop is justified or caused by market overreaction.

If the drop is temporary, or that it is entirely unwarranted, then it could provide an opportunity to buy a share that you may want to own for the long-term. Otherwise, keep your hands firmly in your pockets.

A version of this article first appeared in the Independent on Sunday.

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