The Buying Process Part 1 4 comments

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"Catching a falling knife" is a term used in describing the purchasing of a stock whose price is freefalling. The analogy suitably illustrates the dangers of such an act, and an investor interested in buying these low-probability high-return stocks should be careful before placing the buy order.

In many ways the analogy is true, for the following reasons:
(1)Fund managers dumping, and there is no way for the ordinary investor to tell when their selling will stop
(2)Broker downgrades of the sector or of the company, and their views of the sector could possibly get worse
(3)Illiquid stocks with little institutional attention tend to drift downwards due to little coverage, as investors bail out for liquidity reasons
(4)Insider selling, possibly due to early knowledge of poor future business outlook; heavy overhang if so since they have massive holdings to distribute
(5)For IPOs, often pre-IPO investors bail out to lock in profits, while underwriters also stop price support after the first few days

These are the main reasons for the analogy, and I have to say that generally they are right. Yet the great investors thrive in buying such distressed stocks, chief among them being Warren Buffett in his purchases of American Express and Coca Cola in their darkest days. So there is big money to be made in being contrarian under these circumstances, in making these low-probability high-return bets. One might have a different view of the fundamentals of the company, that the deterioration of these fundamentals is hardly in proportion with the price collapse (especially true with blue chips; witness NOL's price collapse to 70 cents in 2002 after making a loss; it is now at 5 times that price).

In any case, in the purchase of such stocks the key problem is the patience of the investor. Often he would have done some research into the stock before shortlisting it and the temptation to plough money into such a "bargain" (as the price gets cheaper) gets irresistable. Also the satisfaction one gets after buying a stock has been well-documented by psychologists, which further adds to the impetus to buy (compare this to the highs that girls get after a shopping spree). One way to combat this is to have a watchlist of multiple stocks such that one doesn't fall in love with a particular one (and its price) even before he buys it. Another is to let the price settle into a steady equilibrium before timing the purchase. Often the price vibrates about such a price level for some time before it might execute an upward retracement; the so-called equilibrium before willing buyers and willing sellers.