Falling knives cut deep
Don’t try to catch a falling knife.
Do you know the game mumblety peg? As kids we called it knives and loved playing it.
Alas the mollycoddled generations will never know the thrill and the fear of throwing knives at their own and each other’s feet.
Most versions of knives involved two players and a pocket knife. Our favourite version of the game was stretch.
The object of the game is to make the other player fall over from having to spread their legs too far apart. The players begin facing each other some distance apart with their own heels and toes touching, and take turns attempting to stick their knives in the ground outboard of the other player’s feet.
If the knife sticks, the other player must move their foot out to where the knife stuck while keeping the other foot in place, provided the distance between foot and knife is about twelve inches or less. Play continues until one player falls or is unable to make the required stretch.
The ‘traditional version was also fun.
Two opponents stand opposite one another with their feet shoulder-width apart. The first player then takes the knife and throws it to “stick” in the ground as near his own foot as possible. The second player then repeats the process. Whichever player “sticks” the knife closest to his own foot wins the game.
If a player “sticks” the knife in his own foot, he wins the game by default, although few players find this option appealing because of the possibility of bodily harm. The game combines not only precision in the knife-throwing, but also a good deal of bravado and proper assessment of one’s own skills.
There is nothing quite like the fear of a knife in your foot to sharpen one’s skill assessment.
Anyway that’s enough of a stroll down memory lane.
Falling knives
The major appeal of trying to catch a falling knives is rooted in anchoring. Coca Cola Amatil was $15 last year, it must be a bargain at $9!
Last week I confessed to anchoring when selling. Unfortunately I still occasionally fall in to the trap of anchoring with falling knives. I have been closely watching Coca-Cola Amatil (ASX:CCL) since it’s precipitous fall in April. It appeared relatively cheap. Relatively that is compared to its past multiples.
Fortunately Peter Phan of Castlereagh Equity pointed out to me there are other large Australian companies priced similarly that have better growth profiles and less execution risk than Coca-Cola Amatil.
Falling knives present numerous dangers, most of which are as painful as a knife in the foot.
- They can and often do keep falling. Cutting deep as they fall.
- Even when they eventually land they often turn in to value traps, that is the stock doesn’t rebound to capture past glory.
- Those stocks that do eventually bounce often don’t provide a good compound annual growth return. CAGR is the key return long term investors should focus on. If it takes too long for the investment to “work out” then a good absolute return can become a poor CAGR.
Coca-Cola Amatil is a good, but not great example of a falling knife. It has decent underlying businesses and negligible chance of falling to zero.
Speaking of zero, a much better example of a falling knife is Xero (ASX:XRO). Xero is a classic falling knife. Since XRO began falling in March, every single person who has tried to catch this falling knife has been badly cut. And those cuts could get a lot worse.
With no earnings and well heeled incumbents successfully fighting back there is no sign of the floor for Xero’s falling knife.
Xero closed today at $18. And just in case you think I’m jumping on the beat it while it’s down bandwagon, I’ve been screaming watch out below since Xero was $42.
Falling knives are worthy of a place on your watch list. If they fall hard enough for long enough then they can provide sensational opportunities, with limited downside and massive upside.
Hopefully my recent purchase of Maverick Drilling at $0.16 will be a case in point.
The trick is patience. Wait, wait, wait and then wait some more. Stocks can keep falling by yet another 20 percent over and over again. Take Xero for example, it’s closing in on its fourth 20 percent fall from its March high. From here it could easily fall 20 percent twice more in normal market conditions or even 5 more times if a bear market bites.
Here’s an old post on the footwear company Crocs that illustrates just how far falling knives can drop, $75 to $0.79.
Disclosure: Please seek expert advice before playing mumblety peg. I am not authorised to provide advice on knife throwing.
Long MAD. CCL is still on my watch list.
