David Kuo: It can be dangerous playing with falling knives

Investment Insider

"Never try to catch a falling knife" is a City phrase for not buying a share whose price has fallen dramatically.

But it is important to distinguish between falling knives and panic selling.

Take Thomas Cook. Its shares have plunged 78 per cent this year. At the start of the year, the travel agent was valued at £1.6bn. Today it is worth only about £360m. We all know that UK households are struggling under a weight of consumer debt. Thing is, the share price now discounts a considerable risk of failure, which may look tempting. So if you don't lose your money, there is a fair chance of recovery value too. But that is a big "if".

Yell, the owner of Yellow Pages, is another company that has lost a significant chunk of its value. Its shares are down 69 per cent. But what can the company do when it distributes printed material that can become obsolete almost immediately? Somewhat belatedly, Yell is shifting from print media to digital distribution. That's the good news. The bad news is it could take up to four years to put in place. In the meantime, it has a £2.7bn debt millstone that is some 25 times larger than the company itself. So the writing could be in the pixels for the future of Yell.

There are lots of businesses that have fallen since the start of the year, including Dixons, Barclays, Royal Bank of Scotland and Lloyds Banking Group. But according to research from the Brandes Institute, between 1986 and 2002, falling knives posted a higher bankrupt rate over three years after their initial drop.

However, some falling knives outperformed the overall market by a wide margin. If you are keen on chancing your luck, you may want to decide if the falling knife is a temporary situation. Otherwise, keep your hands in your pockets because playing with knives can be dangerous.

David Kuo is director of Fool.co.uk