I once was the type of investor that would dedicate part of my research efforts to seeking out stocks that had recently been hit hard in terms of price. I suppose I thought I was doing what a smart value investor does; look for stocks that recently have been beaten down and buy them. What I’ve learned is that chasing stocks that have recently been cracked is a lot like catching a falling knife; it’s very difficult and dangerous.
When investors in long positions get scared, investors looking to establish a short position start to swarm or a combination of both occurs, a stock is going to get a haircut. Often this will result in a steep drop in share price. Maybe the price will fall 30% and you will think, “Wow! A 30% discount! Time to buy!” Yet, the stock may fall more before all is said and done.
What I notice is that when the tide turns against a stock it will be driven down to a certain level and then react based on subsequent news. If specific news is lacking about the company or industry, then you should expect a period of calm around the base price upon which the stock has come to rest. Additional negative news will push the stock down further. Positive news, if of substance, will pull the stock from the valley it is in.
If you’re in search of a stock that has been beaten down, make sure you know how, when and where a catalyst will come from to change the market’s perception. A stock that has fallen because the overall market is down usually cannot be faulted too much, but when that explanation does not work, you need to know specifically why the market’s perception is going to change.
Remember that investors as a whole are focused on the future. The stock that trades down 30% compared to its close the previous day is not selling at a discount. It’s selling at the perceived fair price by investors based on specific news. If you’re going to swim against the tide, you need to be certain that what lies beyond the common view of the future is different (better) than the current perception.