Falling Knife vs Value Investments

Hi, I'm Jimmy. Have you ever heard of the investing saying that says don't try to catch a falling knife? Basically, it means if a stock is dropping quick, don't try to jump in and buy it. You might as well hear this called don't try to time the market. — [snorts] — But is this the best advice? Sometimes a falling stock is actually an opportunity and not really a falling knife. So here's my real question. Let's imagine we have a stock like this that we've been watching for a while and we want to buy it. And today that stock's down about 5% and over the past few weeks it's down about 30% and over the past almost year it's down about 45%. Well, when we look at this chart, we would say that this is a falling knife. Don't even try to catch it, right? You This is one of those that you might want to avoid. It's clearly having trouble. Okay, now we have a different chart here. Very similar chart, very similar setup and for a while the stock was doing extremely well. Then it had a pretty big pullback. Similar pullback from a percentage standpoint to what we saw before, but I'm guessing that we'd also agree that it's probably impossible to tell just based on these charts alone. Sometimes investors will wrongfully look at a falling chart and call it a falling knife, implying that we got to stay away from a stock that is down big. But that's simply not enough information to say that a stock is actually a falling knife and something that should be avoided. Now let's ask a very similar question but in a slightly different way. Is this stock is this pullback in the stock an opportunity? Instead of being a falling knife that should be in theory be avoided, well maybe this is a value opportunity and we should be jumping into it to buy it. Well, I'm guessing most of us are saying the same thing right now. That if we want to know if this is a value opportunity, one we need to know what stocks these are, but we'd also need to look at the fundamentals of the business. You can't call a stock a falling knife or a value opportunity unless we also look at the fundamentals. Now, technically, in order for a stock to be considered truly a falling knife, it also it needs to be a falling stock that also has a business that's falling apart. If you have a deteriorating business and a stock that's dropping fast, well, that's likely a falling knife. That's technically the more accurate definition, if you want to call it that, of that saying. Although, in many of the comments of the videos I've done, if we're looking at a stock that has seen a pullback, some people jump in and say, "You can't go anywhere near this. It's a falling knife. Don't try to catch it. " But, is it? Is it more of an opportunity? Perhaps the stock is pulling back for more of a technical reason. Or maybe the company announced a bad quarter or they, you know, maybe guidance came in lower than expected. And because of that, the stock had a meaningful pullback. Well, that could in fact be a value opportunity, especially if a company like drops guidance, you know, they were going to grow by 15%. Now, they're 10% and the stock drops 30% over the next few weeks. A lot of times, that's kind of a over dramatic pullback. To illustrate what I mean, well, this chart, one of the charts that I showed before, well, if we ran that chart out into the future, well, this chart was actually a chart of Sears. And eventually, this company went bankrupt, they delisted, and in fact, that was a falling knife. And if we had looked at that stock at that time, if we had analyzed the fundamentals of the business, well, there was plenty of information out there at that time where we had the stock going up to There was plenty of information at that time talked about the deterioration of their business. They were selling off different assets, they were closing a whole bunch of stores. If we had done any actual analysis on the company, not just look at the chart, we would see, yes, that was in fact a deteriorating business and a collapsing stock because of it. But, this other stock that we had looked at, well, we saw that stock had pulled back about 45% off of its high and the stock was getting killed and that company was actually Alphabet. And this just happened a couple years ago. At that time, ChatGPT had just kind of rolled out and or was rolling out and if you looked at the fundamentals of the business, well, the fundamentals of the business were actually doing fairly well, but there were all these rumors going around that ChatGPT was going to put Alphabet somehow out of business. And if we look at some of the numbers at that time, that 2021 to 2022 time period, we can jump in and look at revenue. We can see that revenue was climbing fairly well. We jump over and look at profit margins. Profit margins were fairly steady. Net income, we saw a pull back in 2022, but then it continued resumed higher after that. Now, of course, I cherry-picked these examples, so we have the benefit of hindsight guiding us with this, but there are some tangible numbers that we can look at. When we see a stock pulling back, we can go do some research on that stock to try to determine is this stock currently a falling knife or a value opportunity? Well, first, I'd start with what's

happening with revenue. Is revenue growing? If it's not growing, why isn't it growing? Are they closing down a bunch of stores or perhaps it's more of a one-off situation? Maybe they sold off a line of business or something and that had revenue pull back, but is it a fundamental problem or is it a one-time situation? Then I look at profit margins. Now, generally, I think that looking at gross profit margins or operating profit margins are a good place to start because a lot of those keep out some of the one-off items that, you know, where you saw like a pull back in Google's profit, well, some of that was big accounting reversals that they happened that happened in 2022. Now, what about cash flow generation? How does operating cash flow and free cash flow look? If operating cash flow is growing and free cash flow is growing, well, that's likely to be a good sign for the business. Even if it's holding steady, that's likely to be a good sign. Back when Sears when we looked at where the Sears chart was after it started to pull back, well, operating cash flow was dropping a decent amount. Free cash flow was fairly negative. So, there were plenty of signs at the time to warn us that was a problem. Then, the final key number for us to check is well, key numbers is the balance sheet. How strong is the balance sheet? And one of the things you can look at is debt, cash. If you look at a chart, this is a chart of Google's debt and cash. Now, just picture we're back in 2022, the stock is down 45%. We're looking at this. Look at how much cash they have versus how much debt they have. And I mean, they have an obscene amount of cash relative to debt. The idea of a strong balance sheet is that not that if things if their business were to face sustained pressure, well, do they have the cash to help them to get through that? Debt can be a debilitating problem for them, for any company, and whereas cash is very helpful. And you could see in the case of Alphabet, well, it would have been fairly obvious to anybody who had done an analysis of that stock at the time that would see this and say, "All right, I almost don't care the stock is down 45%. They have the capital to stay in business. " Now, I wanted to make this video because sometimes, as value investors, we may get freaked out if a stock that we're looking at or even a stock that we already own has a big pullback. And it could be really scary jumping into a stock that is falling. It is nerve-racking to jump into a stock that's down 45% and to trust that it's all going to play out. But, if we do our research and we come up with a reasonable fair value, and then we add a bit of a margin of safety on top of that fair value, depending on whatever our analysis has told us, well, a lot of times that alone will help us determine whether or not this stock is a falling knife and should be avoided or is it a value investment. Huge returns that can really help our portfolios can come out of these types of investments and if we can avoid the bad ones, that is just as important as picking the good ones. Right around the time that we had this we did this Google analysis. That's actually when I jumped in and bought Alphabet and I paid a bit under $120 per share and for a while the stock kept falling. It got down into the 80s. So, clearly I could have bought it better. But since that point, the stock is up huge. The stock has been a major contributor to my overall portfolio. But partially that happened because I had done the research and I saw that I saw that big pullback that was happening as an opportunity in that stock. So, the moral of the story is that ultimately we have to do our research. It's really important that we don't just look at the price of the stock and make a decision based on that. We have to do our research. We have to know what stocks we want to buy at what price. A lot of times it helps to keep a bullpen of the companies we've analyzed and what price we want to buy it at and if you're curious, I actually have a bullpen of the all the different companies that I I'm watching and as I'm analyzing different companies, I'll add it to it or maybe take them away if something changes. If you're curious to see that, let me know in the comments below if you want to see a video on the companies that I have in my bullpen. And if you have any companies in your bullpen, please let me know in the comments below. I'm always interested to find new companies. Now, if you want to sign up to get access to the Investors Grow website where we try to make it quick and easy to analyze stocks and using analyst assessments, it helps us quickly and easily come up with a fair value for over 50,000 stocks around the globe. So, I'll leave a link in the description below and right here. If you want to sign up to get access to that and thank you so much for sticking with me all the way to the end of the video. I really do appreciate it. Thank you and I'll see you in the next video.