How to Avoid a Falling Knife - Weekend Wisdom

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We've all been there. A stock plummets in price and looks tantalizingly cheap. Sure, analysts have been slashing their earnings estimates. But you believe the forward P/E and the growth rate still look attractive. So you jump in, thinking the price can't possibly go any lower.

But then you watch in frustration day after day as those earnings estimates - and the stock price - keep coming down... and down... and down. Soon you realize that you've just been cut by a falling knife.

Let's first discuss...

How to Avoid the Falling Knife Stocks

Step 1: Don't buy stocks with falling earnings estimates.

Step 2: Read step 1 again.

You see, no matter how "cheap" you think these stocks might look, the odds are strongly against you. But don't just stop there. Not only will earnings estimate revisions help you avoid those dreaded falling knives, it will provide you with an excellent timeliness indicator so you know precisely when to jump into a stock. By utilizing the power of earnings estimate revisions, you can become a much better value investor.

The Power of Earnings Estimate Revisions

Our research here at Zacks has shown that earnings estimate revisions are the most powerful force impacting stock prices. Stocks with rising earnings estimates have significantly outperformed the market year after year, while stocks with falling earnings estimates have underperformed the market.

Why is this?

Think about what a stock represents: ownership in a business. And the intrinsic value of a business is the present value of all future earnings. So if earnings estimates rise, then the value of that business rises. On the other hand, if earnings estimates fall, then so does its intrinsic value.

It's also important to note that stocks with positive earnings estimate revisions are more likely to receive additional upward estimate revisions in the future. And stocks with negative revisions are more likely to receive further negative revisions in the future. The reason for this is because many analysts will revise their earnings estimates slowly and incrementally.

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In other words, the best way to spot a potential falling knife is to look at the direction of earnings estimate revisions. If they are trending lower, then get out of the way!

A good example of this is with Tesla Motors (TSLA). Shares of TSLA soared throughout the summer of 2013 as earnings estimates surged higher. But estimates began to drop just as the stock was topping. Investors would have been wise to take their profits here because estimates kept moving lower over the next several weeks, and the stock plunged more than -40%. Shares have rebounded a bit since then as earnings estimates have leveled off.

Monitoring earnings estimate revisions can help you avoid some nasty losses. But...

How Do You know When to Jump Into These Stocks?

One of the most challenging aspects of value investing is timing. Let's say that you found a potential investment you like, and it looks cheap. When do you jump in? When it is trading at 8x earnings? 6x? 4x?

The answer to this is vitally important. If you buy at 8x thinking it has bottomed but the stock goes to 4x, then you've lost 50%.

Valuation is a great tool for investors, but it isn't a very good timeliness indicator.

That's the great thing about earnings estimate revisions: they make for excellent timeliness indicators. The astute investor can watch a stock's earnings estimate revisions and identify precisely when a company's prospects are beginning to improve. That's when you want to get it!

Waiting for earnings momentum to improve before buying a stock may not get you in at the very bottom, but you can still get in at a great price while substantially reducing your downside risk. This allows you to rationally "be greedy when others are fearful".

The Bottom Line

If you want to avoid a falling knife, then avoid stocks with falling earnings estimates. Be patient, and wait for earnings momentum to turn around before jumping in. By utilizing the power of earnings estimate revisions, you can become a much better value investor as you will have timeliness on your side as well.

How to Get the Most Out of Those Revisions

If you have been predicting the ups and downs of the market well over the last few years, then stick with the strategies that are working for you. However, if you have a spotty track record, then likely you need some assistance in charting a course to better results.

We here at Zacks have done exceptionally well at calling the market direction and applying the Zacks Rank for a steady parade of winning recommendations.

In fact, most of our portfolios soared past 2013's very robust S&P 500 gain of +32.4%.

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Good Investing,

Todd Bunton

Todd is our Income & Growth Strategist who is noted for adding the spark of Zacks Rank timeliness to value and growth criteria. Find out how to get his private recommendations and those of other Zacks experts. Learn more about Zacks Ultimate.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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    Zacks is the leading investment research firm focusing on stock research, analysis and recommendations. In 1978, our founder discovered the power of earnings estimate revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank. A wealth of resources for individual investors is available at

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