Promising growth stocks like Peloton, Zoom, Tesla, and Netflix have dropped significantly since the start of the year. In some cases, the massive gains they made during the pandemic have been completely erased. Even tech companies like Snowflake, Amazon, and Upstart have struggled, despite continued demand for their products and services.
For some, the issue isn’t with the merits and financial health of each individual company. It is more about overall economic conditions. Growth stocks tend to sell at high multiples, and the current environment of rising inflation and increasing interest rates makes those premiums unappealing.
Many growth investors are scrambling to cut their losses and move their money into more reliable companies. Consumer staples, utilities, and energy stocks are all getting a lot of attention right now. However, there are some investors who see this selloff as an opportunity to get growth stocks at a discount. They are monitoring the biggest losers and buying in after losses of 50 percent, 60 percent, or more.
Here’s the problem with doing so.
Without careful analysis, these investors can’t be sure that the stocks they selected have actually bottomed out. As a result, some unlucky shareholders (for example, those who invested in Peloton) were down 70 percent only to watch in despair another 50 percent decline.
In investment circles, there is a well-known caution against this very mistake: don’t catch a falling knife. But how can you tell if you are risking a knife catch?
What Is a Falling Knife?
From a trading perspective, a falling knife refers to any asset that is dropping fast. For example, when Upstart lost more than 50 percent of its value on May 10, 2022, it was in dangerous falling knife territory. No one was quite sure where it would bottom out.
Peloton stock fell off a cliff in a similar fashion on November 5, 2021. Investors who thought share prices couldn’t possibly go lower bought in — only to find that, in fact, they could and did decline much further. That’s the trouble with trying to catch a falling knife. You might time your catch perfectly. On the other hand, if you miscalculate, you could lose a fortune.
A falling knife can do one of two things: lose its value entirely (bankruptcy) or reverse the trend. Investors with stock in Blockbuster, Enron, Borders, and WorldCom experienced a complete loss. However, those who took a chance on Best Buy, Domino’s, and Zynga when they were down and out eventually achieved impressive returns. What was the difference? Is there a proven method of catching a falling knife safely?
How to Catch a Falling Knife… Safely
There is no guaranteed method of performing a knife catch successfully 100 percent of the time, but there are ways to increase the likelihood of making a profit when a beaten-down stock recovers. It’s a matter of looking closely at key elements of the company’s product, history, business model, leadership, and financial management to determine whether survival and eventual recovery are even possible. Then, a careful examination of stock price patterns can provide insight on exactly when to buy.
Enron and WorldCom are examples of companies that failed because of egregious accounting fraud. When criminal activity is involved, there is little or no chance of a successful knife catch.
Blockbuster and Borders are a little bit different. Their problems more closely resemble the situation Domino’s faced a decade ago. Their products became obsolete, and they didn’t evolve to meet the changing demands of an increasingly digital world.
Both Blockbuster and Borders attempted to pivot as competitors pulled their market share away, but they weren’t able to make the right changes quickly enough to prevent a complete disaster. Domino’s, on the other hand, enjoyed a remarkable turnaround. It succeeded with the help of a bold, innovative new CEO who completely transformed the company in a matter of months.
The lesson is to study a company’s fundamental health. Is the underlying product or service strong, and does the leadership team know how to adapt to a changing environment? Are there signs of growth, and is the company financially sound? Can it afford to make any necessary changes to recover from its downward spiral?
In the case of Peloton, no one is quite sure whether the company will ever regain its former glory. There is talk of transforming it from a fitness equipment manufacturer to a full tech platform, but few are optimistic that this change will do much for share prices. In other words, Peloton isn’t a great candidate for a knife catch.
Upstart is a different story altogether.
In October 2021, share prices topped $400 before they started on the downward trend which culminated in that startling post-earnings drop on May 10th. However, a closer look at the earnings report showed plenty of positive signs. The company’s growth might have slowed a bit, but Upstart is still growing fast. And though business leaders pulled back their guidance for the upcoming year a little bit, the revised expectations are still fairly impressive.
This could present an opportunity to catch a falling knife without getting cut. In this example, as with any knife catch attempt, the safest method is simply to dollar cost average.