Motley Fool Article On Catching The Falling Knife

Discussion in 'Educational Resources' started by eagle488, Oct 24, 2006.

  1. You Have 23 Minutes to Decide

    By Bill Mann (TMF Otter)

    Yesterday was a good day.

    See, back in July, I bought shares of topical drug company Connetics(Nasdaq: CNCT) for a hair more than $8 per share. The company'd had a miserable year so far, enduring a long litany of problems involving shareholder suits, SEC investigations, product delays, and technical defaults. Each hit knocked the stock down a bit further, until the final injustice in July: The company withdrew guidance for the year. The stock suddenly fell into a tailspin, losing more than 20% in a day. That's when I bought.

    The details of that story are not so important. Here's what is important: Yesterday, a private company agreed to buy Connetics for $17.50 per share.

    But I wasn't always correct
    I told you that story to tell you this one: Though I did well with this stock, like nearly always -- OK, always -- I did not catch the bottom. Instead, Connetics dropped another 16% before it began moving up. I bought the day it dropped an enormous amount, but I didn't buy when I first started watching it, even though it had already dropped some 40% from its 52-week high.

    There is an adage that warns investors not to catch a falling knife (i.e., a rapidly falling stock). It's nonsense. That said, one of the worst mistakes an investor can make is to rush into a situation before he or she understands it.

    Here's a scenario: You see a company that you know a little about. Suddenly it drops. An opportunity! You get excited. You don't want to miss out. The market is closing soon. What to do?

    Don't buy
    Take a deep breath. In almost all cases, when a stock drops really fast, it's got a good reason for doing so. You might feel like a stock that was $20 yesterday and $12 today is really cheap, but it might not necessarily be so. Ask folks who thanked their lucky stars in May for the opportunity to buy Pegasus Wireless(Nasdaq: PGWC) at $11, after the stock lost 35% in a week. Today, its shares trade around $0.75.

    Although it may feel like opportunities will disappear in just a minute, it's overwhelmingly likely that they won't. Investing is at its best when it is most businesslike, and there are very few monumental business decisions that have to be made in a split second. If you feel like your entire financial future hinges upon getting in on an opportunity right now, chances are you're wrong.

    But we human beings have trouble doing nothing, don't we? It's a dynamic that sales professionals, including stock brokers and penny stock shills, have been using against us forever. It's hard to see an opportunity and not act. Many times, the question we fail to ask is, "But is it really an opportunity?"

    Don't get me wrong
    There should be no doubt whatsoever that looking for value when the market is running away in horror can be extraordinarily profitable. Personally, I've earned good returns from PetroKazakhstan,Telekom Indonesia(NYSE: TLK), and Novastar Financial(NYSE: NFI), to name a few. Professionally, I recommended Valero(NYSE: VLO) and Coinstar(Nasdaq: CSTR) to Motley Fool Hidden Gems subscribers in 2004 on the exact same principle, generating multibagger returns.

    The principle at play here is one of aggressive patience. After all, in the case of Connetics, waiting several months would have caused an actual opportunity to go by the wayside. But there's nothing in the world that says you have to rush. Some Elan(NYSE: ELN) investors learned this the hard way in February 2005, when the stock dropped nearly 70% in a single day, following news that the company was pulling its multiple sclerosis drug. Investors rushed into the breach at $8 per share, only to see the stock drop by more than 60% from that point, to $3 per share by the end of March. Opportunities don't tend to be so fleeting that they demand instant action. That's our own emotions affecting us, not reality.

    Want some help?
    At Hidden Gems, we're pretty good at unlocking the opportunities that arise when the market panics, but we do so in a measured, deliberate way. We might miss a few, but we also tend to avoid "cheap" positions that turn into costly mistakes. And we're having some success -- our recommendations are ahead of the S&P 500 by more than 20 percentage points on average.

    Bill Mann co-advises Hidden Gems with Motley Fool co-founder Tom Gardner. Click here to try the service free for 23 minutes. Just kidding -- you actually have 30 days to check out everything the service has to offer. Here's more information. Bill owns shares of Connetics and Elan, which we tell you because of the Fool's disclosure policy.
  2. thos mf guyz are topnotch traders and investors... :p