InvestorQ : Are there are any clear signals that a stock could be a falling knife?
sara Kunju made post

Are there are any clear signals that a stock could be a falling knife?

3 years ago

More often than not you are able to identify a falling knife only after you see it falling. One of the first indicators of a falling knife is visible in a shift in ownership. Normally, promoters and global institutions are the first to smell a rat and exit. If you find this happen for 2 quarters, it is a potential falling knife. In most cases in the past we have seen informed investors exiting the stock at the right time.

Watch out for the forex exposure of the business. This is true for companies which have heavy import content as also for companies that have huge foreign currency borrowings. You normally do not have control over the currency. An un-hedged foreign currency exposure can create a falling knife if that currency starts appreciation sharply versus the rupee.

Watch out for debt and the debt coverage ratios. Companies with huge debt books are especially vulnerable to becoming a falling knife. Most of the falling knives in the recent past have been outcomes of too much debt. The problem with high debt is that it simply gets compounded. It has proven time and again that companies with high levels of debt have rarely created value on a consistent basis.

Lack of transparency is something everyone needs to watch out for. Unexplained transactions, too many group companies, too many inter-group transactions, absence of Chinese walls should all be red flags. The Financial Technologies group was a classic example where opacity was a red flag. Later, we saw that in companies like Gitanjali Gems and later in Vakrangee in a big way.

Is the industry in which the company operating undergoing a subtle shift? Look at the way online selling is putting pressure on brick and mortar retail. Look at the way online banking put pressure on branch banking and mobile telephony put pressure on fixed telephony. They created falling knives. Such stocks could create falling knives quite fast and in fact even before you can realize the full impact of the same.

Finally, watch out for the technicals. Is the stock consistently breaking DMA supports? Is it creating new lows regularly? Has the stock suddenly become extremely volatile? Do you see accumulation in deep OTM put options? Is the selling pressure on the screen consistently high? These are typical falling knives. Remember, technicals normally give you adequate warning and you have enough time and the bandwidth to act upon it.