Don't Catch Falling Knives Like Vakrangee or PC Jeweller... - The 5 Minute WrapUp by Equitymaster
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Don't Catch Falling Knives Like Vakrangee or PC Jeweller...

May 8, 2018

Sarvajeet Bodas, Research analyst

What follows is an imaginary conversation between two friends, Ashish and Mohit...about a real stock. If you've had conversations like this with your friends, how do you look back at it?

Sometime in February 2018...

Ashish: Hey, did you look at Vakrangee? It's falling like dominoes. I think it looks good at this level. What do you think?

Mohit: It's a falling knife. There are several corporate governance issues. I'm not sure about their business model.

Ashish: Yes, yes. I've heard about all those corporate governance issues. But it's already discounted in the price. I mean, just look at how much it has fallen. The stock is already down more than 60%. This level is attractive.

Mohit: Be careful, man.

In March, the stock started hitting upper circuits...

Ashish: See, I told you. The stock is already up 50% from my buying level. It was a clear buying opportunity. Many people didn't see it. I think it will go up more.

Mohit: Good for you. But remember, even a dead cat will bounce if it falls from a height. Be careful.

In May, the stock tanked below Rs 100...

Ashish: You were right. The stock is below Rs 90 now. I'm already down 50%. But I'm thinking of averaging down. What do you think?

Mohit: Man, I told you this before. It's a falling knife. Just stay away...

Now forget Vakrangee for a minute.

Have you been in either Ashish or Mohit's shoes at any time in your investing career? Perhaps in both their shoes at different times?

Well, you wouldn't be alone. Many investors make this mistake time and again. It's called catching a falling knife.

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Catching a Falling Knife Can Be Dangerous...


It's happening as you read this...

The Economic Times says, retail investors increased their holding in stocks that tumbled over the past few months. These stocks fell due to either corporate governance issues or worries about the debt on their books.

Retail Investors Buying Fallen Knives
Company Net addition of retail shareholders % change in retail stake YTD change in stock price return (%)
Reliance Communications 55,079 2.9 -54.3%
PC Jeweller 37,646 0.4 -62.8%
Bhushan Steel 37,406 19.4 -64.2%
Vakrangee 37,314 1.8 -79.6%
Electrosteel Steels 18,113 9.9 -71.6%
Jaypee Infratech 17,567 5.5 -77.2%
Gitanjali Gems 12,606 3.3 -95.7%
Reliance Naval 9,670 1.8 -72.5%
Sunstar Realty 9,211 4.7 -83.2%
Data Source: Economic Times, ACE Equity; YTD - year to date

Clearly, the aam investor has loaded up on fallen angels. They expect these stocks to bounce back and give them handsome returns in a short time.

But this is not how India's smart money invests.

In a way, the Smart Money Secrets team is fortunate. You see, the super investors we track don't touch falling knives.

So, at a basic level, we get a nice filtered list of companies to start analysing.

Take our recent interview with super investor, Rajeev Thakkar. Kunal and I had a long conversation with him.

Interestingly, he has given a presentation about falling knives on YouTube.

We asked him about it.

This is what Rajeev Thakkar said:

  • In that (YouTube) presentation, I spoke about, let's say American Express which Buffett invested in and Valeant which Bill Ackman invested in. So, people who favour concentrated investing, people who say buy on declines, would give example of Buffett. So that worked and the other one did not work. So, people who bought Valeant or Bill Miller who went on buying financial stocks in 2008-9, they got it wrong.

    My presentation was in terms of problems which an individual company faces on its business side. For e.g. Import alerts in the case of pharma, PNB fraud, Russia's political meddling in the US in the context of Facebook. So, these are company specific issues, where the company is in trouble in its business front for some reason or the other.

    What to do in that context? Is it falling knife where if you try to catch it, it will cut your hand, or is it something which is potential multibagger in the future.

    So, what I pointed out was - would the government intervene to protect the company? That is one criterion.

    Do the customers still trust the brand, love the brand, and would miss the products is a problem, a near term pain but not fatal or is it fatal?

    So, these are some of the criteria, as I had mentioned in the presentation, a lot of these have to be put together to figure out whether you should buy the company after a steep fall or not.

So, there you have it.

If a stock is on a falling spree, there's probably a good reason behind it. And realising that is the first step towards correcting our investing process.

Averaging down could be a good idea, but not in all circumstances. Gauging the reason for the price decline is the key.

If there are corporate governance issues or debt repayment issues, it's best to avoid those stocks.

Or you could end up like Ashish...

Happy Investing!

Chart of the Day

Today's chart illustrates how retail investors are increasing their stake in stocks that have plunged over the past few months.

These stocks have fallen due to corporate governance issues, lack of management integrity, or debt worries.

Retail Shareholders Are Lapping Up Falling Knives

Take Gitanjali Gems for example...

The stock has dropped by whopping 95% since the start of 2018. Despite this, more than 12,000 retail investors have bought the stock. This amounts to a 3.3% increase in their shareholding.

Clearly, the aam investor would have been better off staying away from such a falling knife. In this case, the quality of the management as well as corporate governance were in question.

Tanushree Banerjee, editor of StockSelect wrote to you about the importance of evaluating management quality in investing. She explained in detail about evaluating management quality by asking some very important questions.

Subscribers to Smart Money Secrets are lucky in that sense.

Why?

Because we believe, India's top 40+ super investors, ask these questions before they put their money into a stock.

And we track them closely.

Then, using our smart money indicators, we narrow down their choices to just one stock per month.

Last month, we recommended a 100-year-old bank.

This month's pick will be published soon...watch this space.

Regards,
Sarvajeet Bodas
Sarvajeet Bodas
Research Analyst, Smart Money Secrets

PS: Do you sometimes wonder how the best investors in India select stocks? Wonder no more! Just let them do the work for you. Kunal Thanvi, editor of Smart Money Secrets can show you how. Click here for a special offer on Smart Money Secrets that ends at midnight tonight.

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