Fleetwood, Seven Group: Beware of ‘falling knives’

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.

The Australian Financial Review says “good quality Australian shares that have a long history of paying dividends are a real alternative to a term deposit.” Get “3 Stocks for the Great Dividend Boom” in our special FREE report. Click here now to find out the names, stock symbols, and full research for our three favourite income ideas, all completely free!

More reading

Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

Top 3 ASX Blue Chips To Buy For 2019

For many, blue chip stocks mean stability, profitability and regular dividends, often fully franked…

But knowing which blue chips to buy, and when, can be fraught with danger.

The Motley Fool’s in-house analyst team has poured over thousands of hours worth of proprietary research to bring you the names of The Motley Fool’s Top 3 Blue Chip Stocks for 2019.

Each one pays a fully franked dividend. The names of these Top 3 ASX Blue Chips are included in a specially prepared FREE report. But you will have to hurry. Depending on demand – and how quickly the share prices of these companies moves – we may be forced to remove this report.

See the 3 blue chip stocks

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.