The art of catching falling knives

Contrarian investing is not for the faint-hearted. Warren Buffett is well-known for telling us to be greedy when others are fearful, but Nathan Rothschild reportedly went much further by advising investors to “buy when there’s blood on the streets”. The biggest bargains are on offer when there’s panic in the air – be it due to political turmoil, economic crisis or even war.

All three of these were ticked in 2022, and the sheer uncertainty that permeated a year to forget meant the quick wins available to investors “buying the dip” throughout a chunk of the 2010s never really materialised. The tech-heavy Nasdaq Composite index racked up some heavy losses in the first half of 2022, only to plunge again in mid-August and catch out those who may have opportunistically bought in. Similar scenarios occurred in many asset classes, including government bonds, where prices tumbled early in the year, throwing up some juicy yields that began to draw investors back, only for another fierce sell-off to strike later on. 

Macro bets also caught out investors, both private and professional: think those who piled into the KraneShares CSI China Internet UCITS ETF (KWBP) in the wake of 2021’s regulatory crackdown only to endure another challenging year. Or the investment manager on emerging markets trust ScotGems, now in voluntary liquidation, who opted to invest in a London-listed global depositary receipt of Russian retailer Fix Price Group on the very day of the Ukrainian invasion.

As these examples illustrate, investors are rightly warned that putting cash to work on the back of big price drops can be like catching a falling knife – the risk of grisly outcomes, in this case downwards momentum persisting or a company even collapsing altogether, is high. A related but slightly different risk is that an individual investment turns out to be a value trap – one that looks lowly valued but fails to re-rate.

As US value manager Richard de Lisle puts it, such stocks can look cheap but then “stay cheap”, never really rewarding an investor’s patience. Less dangerous than a falling knife, such laggards can nevertheless eat into both your time and your returns relative to better opportunities elsewhere.

In either case, it feels like an appropriate time to assess such warning signs, and to examine the best ways of finding something worthwhile in a land of falling knives and value traps. Value investors were at least among the better performers in a brutal 2022, and in a market where everything seems to have gone on sale, their insights can be valuable.

Metrics for success

Different investors will have different measures of price, be it a stock’s valuation relative to its own history, a price/earnings (PE) ratio or a discount to net asset value (NAV) in the case of an investment trust, to list only the most basic options. Investors will also have different views on what exact price might represent a ‘low’ – especially in a time of significant macroeconomic uncertainty. But for starters, it's worth noting how a holistic approach can be more useful than relying on just one or two measures of value.

“The key is to use multiple metrics to capture various parts of the business,” notes Schroders investment director Ben Arnold. “Another consideration for us is to not look at spot metrics but use data that captures the full picture of the business over time.” He, for example, favours the cyclically adjusted price/earnings (Cape) ratio, as a gauge of the price in the context of its average earnings over a decade and an indicator of earnings strength through a full economic cycle rather than at one point in time.

“The main flaw of spot earnings metrics is that they mask the economic reality of a business,” he says. “For instance if a bank has had its first profitable year in a decade, then a spot PE [ratio] is going to tell you a different story to Cape, which captures the ups and downs of those earnings and can give you a more balanced valuation.”

Be it a possible falling knife or a potential value trap, there is always the risk that any lowly valued investment can lurch lower. The costs and opportunities involved are vastly different: investors can very quickly make or lose big money in short order when investing in the midst of a sell-off: 2022 was an easy year in which to rack up losses, but those who put money to work in the downward lurch of February and March 2020 saw a quick recovery afterward. In either case, a low starting valuation offers some room for error. And for those looking to pick up bargains, some broad principles apply.

Signs to buy?

Those catching falling knives are in large part hoping market momentum will turn soon enough, and may be looking to avoid stocks and sectors with specific risks (see below) rather than simply stockpicking via the use of a winning formula. But that isn’t enough in itself: those with a longer-term view tend to seek out certain positive traits all the same.

De Lisle, who runs the De Lisle America fund (GB00B3QF3G69), believes there must be a catalyst for positive change, and that can relate in part to technical analysis and fundamentals. “Is volume picking up and is there interest coming into the stock?” he asks on the first front. Likewise, he (along with those who keep up with the IC's Director Deals updates) sees insider buying as a vote of confidence in the company, and a sign that things could be on the up.

Many of the points already discussed relate to some form of metric, be it PE ratios or the turnover of a company’s shares. But the motivations behind backing – or avoiding – a seemingly cheap stock or sector can also be more thematic in nature.

In a way, successfully identifying value investments can involve a similar mindset to that employed by some of the best-known growth investors: both types try to identify the trends that will endure and the companies that can benefit, or at least withstand and adapt to them.

As Ian Lance, a member of the investment team for the value-minded trust Temple Bar (TMPL), says of how to identify which knives to catch: “Try to identify permanent changes in society and ask who will be impacted. Working from home was a necessity during the pandemic but has remained popular since it ended. This is likely to have a permanent impact on the rail industry, infrastructure that supported commuting such as bars and restaurants, and demand for commercial property,” he says. The apparent cheapness of such companies could well signify a value trap, he adds – although if markets have underestimated a sector’s durability that could also prove a lucrative opportunity.

Professional investors also point to ways of identifying declining sectors using financial metrics. “Look at the long-run return on capital,” Lance notes. “There are certain industries that struggle to make a positive spread over cost of capital over the long run, usually because they are very capital intensive, and cannot store excess capacity to be used at a later date. Examples here would be telecoms and airlines, both of which require huge investment in fixed assets, and for which the marginal cost is close to zero – ie the cost of one empty seat on a plane or of one call carried – hence when there is overcapacity, prices will often decline precipitously.”

Schroders’ Arnold adds other groups to this list, noting that linear TV and media companies are “seen as dinosaurs” in the era of Netflix (US:NFLX) and Disney (US:DIS), while oil and gas businesses with no exposure to the energy transition or renewables could also count as examples. “It is about assessing whether a company can pivot to survive the structural threats,” he says.

And yet that’s not to say companies are unable to withstand such change, or that things can’t improve for a given sector. The Temple Bar team, for one, has bet that energy companies will prove more resilient than the market gives them credit for. Other industries such as tobacco have previously turned out to be much tougher than investors had expected, rewarding the contrarians who bought in at low valuations. Good value investments can also be predicated on the market making an incorrect assumption about a company or a broader trend: de Lisle has made big gains from buying Build-A-Bear (US:BBW) two years ago. Having suffered price falls for around 15 years and focusing on traditional toys in an age of tablets and smartphones, the company arguably looked like a classic value trap. However, de Lisle believes the market incorrectly assumed toy companies were effectively going out of business, and he also wagered that the company would benefit from a post-lockdown nostalgia factor and the wider boost provided by society reopening. Build-A-Bear also employed a marketing strategy that successfully capitalised on these last two points: it’s worth remembering that a company’s fortunes are often best changed by a mixture of internal and external forces. 

Jonathan Winton, a portfolio manager for Fidelity International, notes that internal changes can justify an investment, such as a new management team delivering improved margins or sales growth, or putting greater focus on a more attractive part of a business. “It can also be external change such as competition exiting an industry or demand improving,” he adds. Change stories he has backed before include Kin and Carta (KCT) and Huntsworth (HNT), both of which benefited from “positive change in their business mix, away from lower growth or structurally declining areas, and re-rating from a depressed valuation”, and Chemring (CHG), for whom catalysts included “self-help initiatives”, a recovery in its end markets and both margin and balance sheet improvement.

The lesson about a need for structural change of sorts applies, in particular, for those busy catching knives. An unloved sector, or an unloved market, may struggle to rebound from a broader sell-off in the absence of such shifts.

Time to exit?

The problems with value investing are well known. Fund managers with a value remit may find themselves out of a job before good performance can come through, or just “drift” into less unloved stocks, while the DIY investor might simply tire of an investment that has gone backwards or sideways for a long time with no obvious catalyst for change. Those who call time on an underwhelming investment, however, do run the risk of exiting just before a recovery finally arrives. One quintessential example is Amazon (US:AMZN), whose shares took years to retake the peak they achieved at the height of the dotcom boom before then exploding higher.

So what might justify exiting a position? One reason may be a company failing to successfully make the changes originally planned – be it increasing profits or materially shifting its focus into more lucrative areas. Another may be greater competition, changing strategy or management, or the sign of insiders selling out.

Investors’ defeats can be as instructive here as their victories. De Lisle highlights Sally Beauty (US:SBH), a hair and body products specialist he bought in early 2021 in the hope it could benefit from an increased interest in body image. “It was a cheap stock and we could see the catalyst as stores reopening from lockdown,” he says. “As a bonus you had the chief executive buying stock.” Having bought at $11, he saw the price move up to $24 as retailers reopened, only to retrace to around $12 more recently.

“What went wrong was it failed to grow sales because it was outcompeted by a better competitor,” he says. De Lisle puts this down to the problem of buying “"the cheapest house on the street”, or the most lowly valued stock in a sector, in this case overlooking the threat from Ulta Beauty (US:ULTA), a rival that was “more upmarket, more popular and that didn’t have the same supply chain problems because it was better managed”. The fund manager later realised that a closer inspection of Sally Beauty’s US outlets may have revealed some of its issues. An analyst visit concluded that “the staff are demoralised, they can’t get the product and the stores are dirty”. For now, however, he is biding his time with the stock.

While an on-the-ground inspection and the scuttlebutt approach of speaking to a company’s staff, customers and even the likes of suppliers to assess its fortunes is warranted, it’s not feasible for most non-retail stocks. But reports and accounts can also signal if a value investment might not be playing out as hoped. Sometimes these signs are clear; Fidelity’s Winton notes of property developer Hammerson (HMSO): “The valuation looked very low but the structural headwinds were large and the balance sheet deteriorated over time, so we exited the position.”

Another point he and others make is to closely watch a company’s level of debt – especially given that bondholders sit higher up the capital structure than equity holders if things do go wrong. One other red flag might be if a company has to refinance debt at a higher spread versus the “risk-free” alternative.

As Arnold puts it: “Businesses trading on low valuations often need one thing to turn things around: time. If the business is up to its eyeballs in debt, the creditors will call for their collateral before the company gets a chance to change. When an industry is also going through structural change, we will spend a long time looking at how levered the firm is; what leases are they committed to, is there a pension deficit, how much are the banks owed, how is the debt structured and are there any big repayments due in the near future.”

DIY investors at least have the time to see if a value buy works out, and the resolve to even buy more of a stock if the price is falling but the investment thesis remains unaltered. But falling knives do remain an occupational hazard for the value investor – the task is to make sure as many as possible are ultimately pointing in the right direction.