Catching Falling Knives: Deciding When to Buy
Two well-known ways to get burned in value investing are unknowingly buying “value traps” and “trying to catch a falling knife”. I’ve already written about how we (try) to avoid value traps, and today I’ll tackle the concept of investing in falling knives. The ideas are closely related and often times investments can be both a value trap and a falling knife, but I think about them in subtly different ways.
I’m not sure if there is a formal definition, but a falling knife is a stock that has experienced rapid and extreme price declines. I think of stocks that have “puked out” after earnings misses or other company-specific news and have extreme downward momentum. There are a lot of stocks out there these days that meet this definition.
Whenever the stock of a seemingly good business drops 20-30% over a short period of time, our ears usually perk up. However, it’s important not to buy a stock just because its price is 20% cheaper than the day before. Just because a stock is cheaper doesn’t mean it’s a bargain. A lot of times stocks that fall rapidly do so for good reasons. Their business is deteriorating and the stock was simply over priced to begin with. Investing in these situations can result in losing money, while investing in stocks that are mispriced is a great way to make money. How can you tell the difference?
Seth Klarman and Howard Marks have produced two of my favorite quotes when it comes to trying to decide when to buy a stock that has gone down a lot, and I try to keep them in mind when studying beaten up stocks.
Seth Klarman:
“You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.”
Howard Marks:
“we never say it’s cheap today but it’ll be cheaper in six months, so we’ll wait. If it’s cheap today, we buy it, if it’s cheaper in six months we buy more, and I think that that works much better than an assertion that we know where the market will be in six months.”
Another way to frame things is to invert the question. Rather than asking how to avoid losing money in falling knives, we ask ourselves, how do you lose money by investing in falling knives? Then we try to do the opposite. The answer is not to try to guess where the bottom is but instead study the fundamentals of the company to try to understand what cash flows it will produce. Only then can you decide on a price that makes sense. Once you have confidence in the earnings power of the business, you can make a reasonable assessment as to how cheap is cheap enough.
The key question is what is cheap? We recently wrote about what cheap means to us in our last letter, so I’ll borrow some of the ideas from that. Cheap to us means a business that is priced low enough that it will produce adequate returns without the help of any valuation re-rating. Furthermore, we look for stocks that are cheap enough in an absolute sense that continued valuation multiple compression is unlikely. Stocks that are cheap and, ideally, returning capital, often provide for a “soft floor” for the stock price. When they reach this level they can stop behaving as falling knives.
Below are three principles we try to keep in mind when we’re evaluating stocks that are dropping rapidly.
Buy a stock if it’s cheap in relation to its intrinsic value
Don’t be afraid to invest in stocks that are falling. Remember Howard Marks’ advice: if the stock is cheap today, start buying it today. Buy the stock when it reaches a valuation low enough that you do not need to rely on a valuation multiple re-rating to achieve attractive returns and long-term valuation multiple compression is unlikely.
Let’s say a stock you’re following used to trade at 25x earnings and suddenly disappoints investors and crashes 50%+ over a few months. It now trades at 10x earnings. The stock feels riskier at 10x than it did at 25x because you’re worried its price might fall further. In reality, it’s often now the stock is at its least risky price.
Further, let’s say its business is growing at a durable 5-10% annual rate. This is probably slower than the past which is why the stock suddenly de-rated from 25x to 10x. Regardless, you’re confident it can maintain this slower but still acceptable growth rate.
This business should earn you 15-20% per year without multiple expansion (the sum of its free cash flow yield and growth). That’s a great return. Maybe the stock will go down another 20% and get to 8x earnings and you ended up buying early. You missed the bottom, but your goal shouldn’t be to earn the highest possible return on every investment, it should be to hit your return hurdles over long periods of time, and you clearly got a good price.
If you have a high bar to activity and are looking for investments that can earn 15%+ for an enduring period of time, you should be looking for investments that can earn you 2, 3, 4x or more of your capital over 5-10 years without taking too much risk. If you uncover an opportunity that you think can make you 4x your money over 10 years, who cares if you buy it a little early and it initially goes down 10-20%?
A couple of caveats here are important, and I’m speaking from the experience of making these mistakes.
It’s far easier to buy what appear to be falling knives when the narrative around the company doesn’t match the reality. In other words, there is pessimism about the stock or its industry but its fundamentals are still intact and the company is still performing. This differs from a turnaround when results are poor which is causing the stock price to crash.
It’s harder to buy into a declining business or a structural turnaround. The problem is it’s easy to be fooled by a cheap trailing valuation when on a forward basis the stock isn’t as cheap as it looks, because earnings are set to decline in a big way. We’ve gotten burned a few times in situations like this where we knew earnings would decline in the short-term but we underestimated the magnitude of the decline and in hindsight ended up overpaying. It’s ok to be a little early, you can still make great returns. Being too early can be a euphemism for overpaying and look indistinguishable from being wrong.
Our preferred instances are when a company that is a structural grower runs into a growth slowdown which causes its previous investor base to panic. Often the stock will overshoot to the downside and a business that is temporarily experiencing flat to slow growth but is likely to grow substantially over the next decade will suddenly be valued as a perpetual no-growth business. More on that below.
An even better setup is when a structural grower continues to grow in line with history but its stock price falls precipitously. These are more rare and are usually “back the truck up” situations. These situations usually arise due to unwarranted pessimism around an industry, a company scandal, or other one-off exogenous events that impact the narrative around the company but not the actual performance. Think McKesson in 2020 around the opioid crisis, Meta in late 2018 after the Cambridge Analytica scandal, or Moody’s during the financial crisis. We think there are a few of these right now creating major dislocations in price vs value.
Be prepared before you buy
Before we buy, we have a plan for either buying more or getting out. The key here is to use the business performance to guide decisions, not the stock price.
When we wade into an investment, we make sure to have a plan as to which business metrics we will follow to know if we are on track with our thesis or not. These are usually volume and price related data specific to the unit economics of the company. This requires that the company provides shareholders with useful metrics, which isn’t always the case. Often, we suspect a business may be a good investment but if we don’t have the data to track how the business is doing we have to discard the idea into the too hard pile.
We have a limit of how much capital we will put into any one position (10% at cost) and sometimes we buy the entire amount right away, while other times we’ll split it into a few tranches. If we do not have a full position initially, we watch the business performance and stock price and if it reaches out next price threshold, we buy more so long as the business is performing as expected.
Alternatively, if we realize we were wrong about the business, whether it’s a month, a year, or five years later, we will sell. Don’t anchor to your purchase price. If you were wrong about the business, often the best course of action is to sell the stock and do the best you can to learn from it. Be prepared when you go in that this could be an outcome and write down the criteria that could arise to prove your thesis wrong.
Keeping your eye on the business metrics takes the pressure off watching the stock price too closely and can free your mind from worrying about trying to catch the bottom.
Be patient but not stubborn
Buying into pessimism can be highly rewarding, but it also takes patience and a strong stomach. Be prepared to wait a few years to be rewarded. At the same time, it’s crucial to not be stubborn and allow thesis creep to enter into your process when there are signs you were wrong. Point #2 about having a predetermined plan of what metrics to follow is crucial in order to enable patience. If you don’t understand the business behind what you’re buying, you are likely to fall victim to letting the stock price drive the narrative and won’t be able to think independently.
One of my favorite Buffett quotes is:
“The stock market is a device for transferring money from the impatient to the patient”
Patience is required for superior investment returns (at least if you follow our approach). It means not panicking when your investment inevitably falls in the weeks following your purchase. It also means not selling too quickly when you’re lucky enough to watch a new investment rapidly rise in price. Give your businesses the time to compound. Give them time to prove you right.
Stubbornness, on the other hand, is holding onto an investment when you were proven wrong, or worse, doubling down because the stock price falls further when there are red flags. Patience and stubbornness are cousins and it’s easy to confuse the two but it’s important to know the difference.
There are a few sectors today, particularly health insurers and software stocks, discussed more below, that likely have falling knives that could cut you. The same sectors might also be filled with asymmetric long-term investment opportunities. Our job is to decipher between the two.
Next, I’ll walk through some examples of these rules in practice with a few relevant companies.
We’ll start with Fiserv, a company that we wrote about in late 2025 and a timely one since they reported earnings this week. Is it a falling knife or a mispriced compounder?