Investing - Falling Knives: Part 1

The entirety of this article relates to the results of the Brandes Institute study on falling knives found at www.brandes.com/institute

In 2003, The Brandes Institute published the study, “Buying the Wrong Stock for the Right Reason”, which explores the validity of the Wall Street adage “never catch a falling knife.” This longstanding maxim advises investors to avoid purchasing stocks that have declined sharply in a short period of time.

According to the study, when it comes to bankruptcy risk, the warning may be warranted. While the annual bankruptcy rate for publicly traded companies is under 1%, a full 13% of the “falling knives” identified in the study went bankrupt within three years. However, investors who “never catch a falling knife” might be missing an opportunity to earn significant returns. On average, the falling knives in the study—including those that went bankrupt—outperformed the S&P 500 Index by an annualized 8.6% over the three years following their identification.

At Brandes Investment Partners, we recognize the risks inherent in investing in companies that may qualify as falling knives. At the same time, we also believe that in some instances, falling knives can represent compelling investment opportunities. This document examines the factors that can lead to sharp stock price declines over a short period of time—why they fall—and points to some examples among the falling knives identified by the Brandes Institute’s study. From there, we explore the components of an investment approach that can help distinguish between “butcher knives,” which might be headed for bankruptcy, and “butter knives,” or those with more promising characteristics.

We recognize three primary types of reasons: (1) company-specific problems, (2) top-down issues such as geopolitical changes or industry difficulties, and (3) elements of investor psychology, which can create additional downward pressure on an already-decreasing stock price.

1. Company problems
A wide variety of company specific issues can contribute to a sharp decline in stock price over a short period of time. For example, bankruptcy fears stemming from high levels of debt relative to cash can push down stock prices quickly. Similarly, profitability concerns on the heels of overreaching expansion could lead to steep price declines. A third type of company-level difficulty is fraud: revelations of corporate malfeasance can drag down a company’s stock price rapidly. Fraud disclosure contributed to stock price declines for Cendant, one of the falling knives identified by the Brandes Institute’s study. In 1998 (shortly after its formation via the merger of hospitality giant HFS and direct marketer CUC International) Cendant revealed that pre-merger accounting irregularities at the latter company had inflated its revenues and pre-tax profits by roughly $500 million. Cendant’s stock price proceeded to plummet, and the company entered the study in September 1998, when its stock’s 12-month decline reached 62.5%. In the year following this collapse, Cendant’s stock rebounded strongly, earning a total return of 52.7% versus 27.8% for the S&P 500.

2. Top-down issues
Like company-level problems, a variety of top-down issues can lead to rapid, substantial stock price decreases. Geopolitical changes including currency devaluation or political upheaval can influence a range of companies in a particular country or region. Additionally, fast-developing difficulties such as new regulation, technological change, or cyclical shifts in supply and demand might cause sharp declines for several companies in a given industry. In 1998, industry and geo-political concerns affected the price of De Beers Consolidated, the world’s leading diamond producer. De Beers entered the falling knife study in August 1998, after a 64.1% one-year decline in the price of its ADRs (American Depositary Receipts). Some market observers believed that the Russian government—in need of hard currency—would withdraw from the global De Beers diamond cartel, and that diamond prices around the world would plunge as a result. As this top-down concern subsided, however, the price of De Beers ADRs surged, rising 148.0% in the year ended August 1999 versus a 39.8% gain for the S&P 500.

3. Investor psychology
Investor psychology represents another important source of additional downward pressure on a slumping stock price. Because of a tendency to extrapolate improperly, for example, an investor may view a steep stock price decline over the short term as a reliable indicator of continued declines in the future. Similarly, a propensity for overreaction might lead an investor to conclude that the recent bad news weighing on a company’s stock price is ominous enough to doom the company entirely. Other psychological stumbling blocks include anchoring, where one given number unduly affects a person’s estimate of a second unrelated number, and framing, where asking a question in improper context can lead to dangerous answers.

Overall, tendencies like these can be important contributors to the price declines that distinguish falling knives. In addition, as we explore in Part 2, investor psychology also might play a key role.