To catch a falling knife

Owch.

If you haven't done it, you've not been investing long enough or you're simply lying to yourself.

This colorful metaphor describes buying a company when its share price is in free fall. It's not finished falling when you "grab" (buy) it and you're definitely going to get hurt (financially).

If you are a value investor, it's difficult to resist buying companies that you've admired for a long time that suddenly become attractive on paper because the fundamentals we watch so carefully (i.e. the P/E ratio) go the "right" direction. Unfortunately, there is usually a good reason for this--- cheap stocks are usually cheap for a legitimate reason. Efficient market theory is often correct (more so over the long term, but that's a different topic).

If you want an example of a falling knife look at PIR's chart for the past 5 years at the top of the page. Guess who bought several million shares at $16 a few years ago and then capitulated at around $7 for a huge loss last June? Mr. Buffett, himself. I'm certainly not one to criticize as I jumped in there at $6.00 and managed to sell at a minuscule profit before it continued it's downward slide to $3 range.

If WB can make this mistake, anyone can. He has said many times that he only expects to be right in 6/10 of his choices so you should not set such high standards for yourself.

Here are some strategies to reduce the need for palmar suturing:

1. DO NOT RUSH. Force yourself to study a stock for 2-4 full weeks before buying it. Opportunities that need you to act immediately are more often than not based on incomplete information or even out in out scams.

2. KNOW EVERYTHING YOU CAN ABOUT THE STOCK. Read at a minimum the last annual financial report and the last quarter's conference call transcript before you buy. As I've mentioned elsewhere, if you're pressed for time (don't be), read the CFO's presentation and the Q&A grillfest the analysts put the execs through at the end. That usually avoids all the hype/salesmanship and gets right to the cold, cruel numbers you need to know.

3. VOLUME MATTERS. Watch the "volume" numbers (shares changing hands) on a day to day basis. The actual number isn't important-- it's how it compares from day to day. As capitulation hits and the last few shareholders give up on a rebound and finally sell their shares, the volumes drop off for a while (days to weeks, depending on how high profile the stock is). When the price starts to rise while increasing volumes, the value investors have stepped up to the plate with conviction. This is the time to pull the trigger. Having said that, I don't think I have EVER successfully picked a stock's true bottom.

4. BUY IN INCREMENTS. Unless you have very strong conviction or you're only buying a small number of shares (all you can afford), then divide your capital into thirds and buy in minimum one week intervals, hopefully at slightly lower prices each time.

5. BUY ON LONG TERM VALUATION. It's ok to ignore short term reverse catalysts like lawsuits or war. If a stock is falling because it was previously overvalued and it's long term opportunity for growth may be decreasing, then stay away. SBUX (Starbucks) may be a recent example of this.

6. IGNORE THE MEDIA PUNDITS AND THE ANALYSTS. With a few exceptions, they are momentum oriented. A quarter or two of positive or negative stock movement and then they'll change their mind--- too late to the party as usual.

7. STUDY THE GURUS and THE INSIDERS. Only when they put their money where their mouth is. If their stake is in the multimillions, they have conviction. Don't pay too much attention to hedge fund gurus like George Soros. They change their positions more often than their underwear. If Dreman, Whitman, Buffett, Dodge & Cox, Tweedy & Brown, Brian and John Rogers, Cunniff etc take a position, factor it in to your decision making. Always keep in mind that you will be getting this information up to 3 months after the fact. Don't chase the gurus. If the stock is dropping AFTER they bought it (USG is a great example) and it meets other criteria, that's helpful. Always keep in mind that there are many great opportunities that the gurus cannot buy that you can because of the scale of their investments compared to yours (often small to mid caps are not an option for them)

8. FOCUS ON THE COMPANY'S MANAGEMENT OF DEBT. Don't get freaked out by big debt numbers-- compare it to comparable (by market cap and sector) competitors. Certain cyclic industries and banks require leverage to grow. Value investors love to buy quality companies in distress due to short term self limited problems (usually due to external factors outside the company's control). The goal is for you to determine if the company has enough liquidity to weather short term debt (i.e. interest coverage and/or short term mandatory debt payments due over then next 12 months). Fortunately accountants have determined measures to help you assess this- my favourite is the quick ratio (like the current ratio but takes inventory out of the equation-- many inventories are not liquid). A QR of greater than 1 is reassuring. Some industries commonly have QRs less than 1 (retail) and still perform well for shareholders. To analyze these companies further you need to delve into detail about how rapidly the co can sell its inventory when needed (without "channel stuffing") and how many slow paying customers it has (accounts-receivable turnover) as well as interest coverage ratios. Personally, I leave this stuff to high powered securities analysts and stay away investing in them. Better to put those stocks in the "too hard" pile.

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