 Good day fellow investors. Despite the fact that the SAP 500 has been going nothing but up, there have been a lot of companies that have seen stock prices significantly decline. We'll use a few examples and we'll derive 10 rules how to catch a falling knife. To catch a falling knife is Wall Street slang for buying a company that has seen a steep decrease in their stock price and trying to pick the bottom before the reversal, if there is a reversal. It's always nice to buy something at the bottom and see it shoot up, however it's very difficult to time. We'll try to discuss 10 rules that will show you how to catch the bottom if possible. A nice example of a stock that bottomed in January 2016 is Capstone paper and packaging. They are in the business of producing corrugated paper and there has been a slowdown in the sector and they have had some issues with their last acquisition. This lowered their temporary earnings, analysts become very negative and the stock price dropped from above 40 to below 8. Nevertheless the sector returned, it's a positive sector and the stock price quickly recovered to the current 23. Those who bought like me in 2016 have enjoyed a very very nice return. So the first thing to look when catching a falling knife is whether the sector is temporarily in trouble or there are structural issues. If the sector is a growth sector then we know that supply and demand will be stronger, will be weaker but the trend is strengthening and increasing demand which is always good for stocks and there is a higher probability that stocks that are currently in a slump will be saved. However if the trend is declining like retail food stocks for example then it's very difficult that their news that those earnings will improve. So always first look at the sector and the trends in the sector. A great stock to show how there doesn't have to be always a bottom is GoPro. Sometimes the bad news keeps compounding, compounding and the stock price drops hugely. GoPro was a stock trading above 90 a few years ago, now it's trading at 9. That's a 90% decrease over the last few years. And GoPro is an excellent example to explain the the psychology of catching a falling knife. According to Daniel Kahneman, Nobel Prize winner and the author of a great book Thinking Fast and Slow when catching a falling knife investors tend to take action based on intuition rather than on analysis. So you see the stock price dropping quickly, you think oh it's a bargain, it's a bargain and you intuitively buy instead of sitting down and analyzing what's going on. Take your time, don't rush it, if you miss an upward trend okay you have missed but don't rush, analyze the stock first. Secondly going back to GoPro another behavioral element is that investors anchor their investment decision on past prices. When you see GoPro at 9 and you see that it has been at 90 you think oh it's a bargain, I'm buying 10 cents on the dollar. However there is no guarantee that GoPro will return to 90. Thirdly investors tend to think that they have something special that others don't have. For example if you are a GoPro user you like the quality of the camera you will think that the same quality will apply to the stock which is the wrong way to approach investors. And thirdly according to Kenaman is that the market is fundamentally unpredictable. You can perhaps predict what will happen next quarter but seeing what will happen especially in such companies like GoPro with very variable results and a lot of competition it's very hard to predict what will happen in the next six months and then it's very hard to predict how will Wall Street react. What's very funny with GoPro is that they beaten estimates, beaten earnings per share but nevertheless the stock price dropped with their last earnings. Very very interesting to see the behavioral part and the economic part of investing in stocks. So before buying a declining stock rule number two analyze your own behavior. Am I in love with the stock? Am I anchoring myself to past prices? Am I intuitively buying or am I buying on great analysis? Am I thinking that I'm smarter than the market and that I know much more? And am I able to estimate future earnings? If not then skip and go to the next stock. So Nobel Prize winner Richard Taller showed that buying losers leads to higher returns. So there is an overreaction in the market and if you buy when the market overreacts you will probably do better than the market. However Richard Taller analyzed only one month returns, not five, not ten years, not quarterly returns. So if you want to take advantage of the overreaction be sure to take advantage in the short term because in the long term next quarter there can be even more bad news coming. So be quick if you want to take advantage of sharp price drops. Now there is a cliche on Wall Street you should never buy a falling knife. However if everybody thinks like that then when something starts dropping nobody wants to buy it and it just drops drops drops until it becomes an extreme bargain. So what do you have to do? You have to become the specialist in the field. You have to know the sector better than anyone else and you have to know the stock better than anyone else. Seems overwhelming? Well it isn't. With my experience on Wall Street I can tell you that there are some stocks that perhaps have one or two analysts following them. So all you have to do is know more than they know about the company and the sector which is not difficult especially companies from emerging markets that are not covered they put the worst analyst on that stock and you can easily beat that with a lot of research. And if you do a lot of research and you find that the trend is negative just buy put options or short the stock so you will get rewarded for your efforts. And this leads to rule number five. Manage your risks carefully look at what can happen in the worst case scenario and see perhaps if it's better to buy options for low risk high return investments. Those are very volatile investments catching falling knife and you have to see what's the price of the options compared to a normal investment in stock and where is your lowest risk for the highest return. When seeing a falling stock you try to calculate the intrinsic value of the stock and then in the long term that price should come to that intrinsic value. However when you calculate your intrinsic value assume that the negative trend that the bad news that have lowered the stock price continues in the future and then get a negative intrinsic value really pessimistic intrinsic value. And if the stock price is below that pessimistic intrinsic value then it's definitely a buy. However try to think negatively and try to think like the market. You will miss on some opportunities that will rebound sooner but you will definitely lower your risk. Number seven diversify. If you diversify on more falling knives and you're really patient because every month every week there are a lot of falling knives you can diversify you can lower your risk and increase your returns because if you're right just in 50% of the cases let's say five of the falling knives you buy double three stocks do nothing and two go bankrupt your return will be 30% in one year which is an excellent return and you were right just in 50% of the cases. If you put all your money on one stock and you're wrong you lose everything and that's very bad in investing. Number eight when you buy at the bottom and the stock price starts rising apply the same principles that you have applied when buying at the bottom to the trend upwards. What's the most positive scenario how long can the trend go because you want to take advantage of the positive trend as well as you did with the negative trend. So really look what's going on will there be more positive news or bad news positive scenario negative scenario and try to ride the trend upwards don't sell after 10% if you have bought a stock that has fallen 90% you want to take advantage more than 10% if the trend reverts and if you have bought on sound healthy fundamentals. Number nine learn to say no the more falling knives you analyze the better you will become into finding the right ones and then allocating your capital to the ones that bring low risks and higher returns. No no no no every day the stock market will offer you a new opportunity if you look at 400 opportunities in a year and you pick just five imagine the quality of those opportunities the criteria that those five opportunities meet and the possible returns at low risk that you can manage. If you look at five companies and buy them just because the stock price is down you're buying intuitively not based on analysis so the more you research the more you say no the higher will be your returns. Number ten the most important rule look for a margin of safety in the worst case scenario if there is complete safety be it cash be it book value be it a takeover be it something even if the CEO resigns even if there are accounting issues even if I don't know there is a recession then you know okay I can buy this falling knife and in the long term there will be no capital loss for me so always look at the margin of safety. So the point is the more effort you put in the more knowledge you have the higher will be your returns the lower your risk. It simply takes time a lot of years of learning but if you like it and if you're willing to do the work you can achieve great returns by buying falling knives. If you're not willing to do the work then simply say no and let the business to somebody else. Thank you for watching looking forward to your comments and I'll see you in the next video.