Don’t catch a falling knife

This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

– The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
– There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
– There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.