For investors not familiar with the term 'falling knives', the image of the danger of trying to catch a sharp knife as it is falls, spinning quickly to the ground, is easy to imagine. Much safer to wait for that knife to hit the ground and come to rest before reaching down and carefully picking it up.
This scenario can be applied to investing. A company that hits some turbulence and sees its share price falling can look appealing and indeed safe to catch, however things can get worse and sticking your hand out to buy stock can lead to nasty cuts as the company's earnings and prospects continue to deteriorate, with the share price falling much further than you expected.
Behavioural economist James Montier, who is the author of numerous great books and articles, is a fan of taking the 10-year average earnings per share (EPS) of a company and comparing it with current earnings. As Montier states in his book Value Investing: Tool & Techniques for Intelligent Investing:
"Stocks which look 'cheap' based on current earnings, but not on average earnings, are the ones that investors should be especially aware of, as they run a greater risk of being the sort of stock where the apparent cheapness is removed by earnings falling rather than prices rising."
While it is important to be forward looking as an investor, historic earnings in established companies can often provide a conservative base case, through-the-cycle estimate. This is particularly relevant for cyclical businesses, such as resource and resource-exposed companies. It is also important to acknowledge that 10 years may not be long enough to view a cycle. For example, the current resource boom has elevated earnings for over 10 years now.
Knife 1
Caravan and accommodation manufacturer Fleetwood (ASX: FWD) is a well-run company with well-regarded management and a conservative balance sheet. Couple this quality business with a 50% loss in value in just one month and value investors are bound to be sniffing about. The potential trap here is that while based on 10-year average EPS the investment case looks appealing, if investors strip out the years where Fleetwood was likely 'over-earning' to account for the 'mining boom' then the average earnings drop substantially.
Knife 2
Seven Group (ASX: SVW) is another decent business with quality management including founder-owner billionaire Kerry Stokes as Executive Chairman. The company has lost nearly 20% of its value in the last month; however it may be too early for investors to jump on board here as well. Its monopoly licenses for selling Caterpillar heavy machinery are certainly attractive assets, however the softening in sales could go much lower than investors currently 'catching' the company now realise. Two companies worth watching for insights into how Seven's Caterpillar business might be travelling are Boart Longyear (ASX: BLY) and Caterpillar (NYSE: CAT).
Foolish takeaway
Fleetwood and Seven Group represents just two of many potential 'falling knives'. The earnings downgrades and subsequent share price falls in the mining services sector mean there are likely many 'falling knives' currently in the air, with only some now lying on the floor. Investors need to select carefully and do their homework to determine how temporary or permanent the decline in earnings power is.
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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.
