When To Buy Good Shares On Bad News

Grasping a falling knife is dangerous -- but it can be lucrative.

On the whole, it's probably fair to say that these situations are best avoided unless you're fortunate enough to have some kind of insight, or you've done some in-depth research beforehand and are aware of some inherent value, but haven't yet bought. Anything else is pure gambling.

It can be fun

Here's the thing though; buying a company you think has been way oversold is often good fun, particularly when you get it right. But how do you decide? And how do you decide whether to buy more if you've gone in too early and the price has fallen further still? After all, in the heat of the moment prices can slide much further than you ever thought possible -- so your decision to buy was, unequivocally, "wrong" in that the price slid further, whatever happened next.

Having said that, you're very unlikely to hit the absolute nadir; this is akin to hitting a moving target. So there are times when you have to have confidence in your own judgement, to show a little forbearance as you wait for the value you've spotted to be realised, and to decide whether it's going to be sensible to buy more at an even lower price.

Cheap is cheap
Doing this takes bottle. But companies are cheaper when they're cheaper... usually! This may sound obvious but it's worth remembering -- though it depends on the specific reason for the fall.
It's also worth remembering that the market may well know more than you do, so only invest what you can truly afford to lose in its entirety, because you can guarantee that this will happen from time to time (unless you're uber-cautious) when you play this game.

The good news is that you'll also get quite a few right and these may well go on to be multi-baggers. The trick is in making sure you have more winners than losers -- but how do you achieve this?

That's the way to do it

The former Scouts among us could do worse than to remember to "be prepared". Most bad news which causes a sudden and rapid drop in price comes as a surprise. The announcement is made at 7am, and you have an hour before trading starts. So if some bad news piques your interest, use the hour wisely to determine your own perception of fair price given all the knowns.

I try to follow Ben Graham's advice in such situations and look at current assets (stocks, short term debtors and cash) and subtract all liabilities (short and long term creditors). I also consider overall net tangible asset value and make my best guesstimate of future earnings before estimating the company's likely value.

Healthy pessimism

Remember to take a healthily pessimistic view of the valuation of assets (excepting cash of course); they won't protect your investment much in a "fire sale". Remember, too, that the previous share price is completely irrelevant. The fundamentals today are all that's important when the chips are down.

It's often wiser to wait until there's hard evidence the company has turned the corner before buying. You may miss the initial rapid rises, but can still get in on the long term recovery.

Companies with low price-to-sales ratios (PSRs) are usually high risk, high potential reward situations. But beware of the risks here -- enterprise value vs. sales is a better measure. Too much debt makes the company disposable.

And finally, watch the cash-flow and beware of short debt repayment times. It isn't losses that finish a company off, it's being unable to repay debts. Good luck.

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