David Holding considers whether Fools should invest in a company which has been hit by a big share price fall.
The short answer for many investors is "never" but I have to say that I love a bargain and have had a few successes as well as some notable failures with falling knives. There's nothing wrong with a bit of excitement now and again -- as long as you're aware of the risks.
A falling knife refers to a share whose price has dropped significantly in a short period of time. These are often high risk situations, but which also carry the potential for high rewards as David Kuo previously explained here.
Much of your decision will depend on how much risk you're prepared to take. Are you really willing to lose your entire stake?
Personally, I'm averse to losing the lot these days. It still happens from time to time but I come out well ahead overall. So how do you decide?
Crisis investing
Many knife-catchers like to jump in after a profits warning. It's not hard to see why. I bought TMF bulletin board favourite Chieftain
(LSE: CFT)
following this relatively mild warning in September 2005 at 58p. It's now 209.5p. Why did I buy? Because the warning amounted to little more than a delay, and I'd gleaned a lot of excellent background information thanks to some of The Fool's star posters, such as "Carmensfella".
Of course, most profits warnings are far more severe. Consequently, the risks are much greater -- as are the potential rewards. Quite a few Motley Fool aficionados bought Ashtead
(LSE: AHT)
just at the point where it appeared likely to go pop in early 03. The chart shows you what good idea this was in hindsight.
Then again, many of us also bought Mayflower and Carbo which are sadly no longer with us; our losses were total. These latter two were companies with high debts but low price-to-sales ratios (PSRs) which makes them high risk, but high potential reward situations.
A big winner for me was Renew Holdings
(LSE: RNWH)
which I bought under its old name of Montpellier three years ago when the company warned on profits and was then threatened by animal rights activists over the construction of a biomedical research facility. The shares halved to under 20p, but have since recovered to 114.5p as I write.
So how do you decide?
It's more or less impossible to know which companies will stagnate or go bust and which will multiply. The fact is that some companies which have gone to the wall might have been turned around had the banks decided it was a good idea to continue their support.
But to maximise the winners and minimise the losers, here are a few tips:
- Wait until there's definite evidence the company has turned the corner before buying. You'll miss the initial rapid rises, but may still get in on the long term recovery.
- Ignore the previous price of the share. If your analysis says a share is expensive given the risks, then the fact that it's fallen 90% is an irrelevance. The fundamentals today are what's important.
- A low PSR is good. It means a small improvement in margin will give a big improvement in profit and it makes the company an attractive bid target as you can buy sales on the cheap. But beware of the risks here -- enterprise value vs. sales is a better measure. That's because enterprise value includes debt -- unlike market cap -- and too much debt makes the company disposable.
- Watch the cashflow and beware of short debt repayment times. It isn't losses that finish a company off, it's being unable to repay debts.
- Beware of negative net assets. Personally, I only look at tangible assets in a crisis. And even they may not be worth a lot in a "fire sale". Try and get some knowledge of what tangibles consist of.
- Overall, be truly aware of the risks. Catching falling knives is a dangerous game.
