Catch These “Knives” – Make 100%

Reading a lot is one thing, but separating the wheat from the chaff when researching for good investment ideas is something else entirely.

If you spend as much time testing various ideas and concepts about investing as I do, you will find that good ones are far and few between.

It seems everyone has some great new idea on how to get rich in the stock market, but I have discovered over the years that most of them do not stand up to rigorous review.

Even worse, we find some strategies that worked very well until too many people found out about them and they got traded out of existence.

Along with plenty of other folks that spend lots of time studying the markets, I have concluded that the only enduring methods for making money in stocks are based on one of two factors – momentum or value.

Anything not based on these is quite likely to be flawed of eventually be arbitraged out of existence by machine traders and other quick-moving traders.

However, today I want to share with you one rather unique “falling knives” investing method that will help you profit…

This Legendary Research Reveals “Falling Knives” Outperform Over 10 Years

The investing method that I want to share with you today was verified by the Brandes Institute.

The Brandes Institute was formed by Charles Brandes, a legendary value investor from San Diego. The institute studies the markets and finance, looking for ways to help investors improve their performance.

Mr. Brandes has ties all the way back to the beginning of the whole value investing concept. When Ben Graham retired to La Jolla California, a very young Charles Brandes was the lucky stockbroker who had desk duty when Ben walked in to open an account. They became friends, and Graham tutored Brandes on the ins and outs of successful investing.

The institute did a study back in 2004 called “Catching Falling Knives.” The study looked at what happened if you bought stocks that had plunged by at least 60% in price over the past year.

The study found that bucking the traditional Wall Street adage, ‘never try to catch a falling knife,’ actually outperformed over the next year and beyond.

In other words, the study showed that it was better to buy stocks while they were falling, rather than wait and try to time the bottom before buying.

However, the study also found that most of the falling knives actually underperformed the market and that all the outperformance of the strategy came from a handful of stocks that staged powerful recoveries with triple-digit returns for several years in a row.

So, the Institute research team spent some time looking for variables that helped isolate these super stocks. They discovered that, at the time of the study, focusing on those stocks with a low enterprise value to sales ratios helped screen out the losers.

Keep in mind, this strategy of investing in “falling knives” only works for those with a long-term mindset. Trying to implement a short-term trading strategy around the falling knives concept would be disastrous.

And that’s exactly what I found when I applied my own research to the study…

Back-Testing Verifies the “Falling Knives” Approach, But Only Through $1 Billion+ Companies

I decided to start doing some follow-up research to the study, and I found that it’s still a very successful investment approach.

Over the last decade, buying large-cap “falling knives” has been a wildly successful strategy.

Specifically, I found that focusing on those stocks over $1 billion in market cap with a one year or longer holding period worked very well.

Unfortunately, as I looked at stocks below $1 billion and added variables to weed out the financially distressed companies that were going to zero, the enterprise value to sales ratio was no help at all. The market has changed and that measure is no longer an effective sorting tool. I am going to keep working to find a good “get rid of the junk” measure, but for now, the knife catchers among us must stick to larger companies.

When I limited the study to just those stocks with over $1 billion of market cap, I found something else. As you can imagine, there are never that many of them at any given moment in time. What I found was that when there were more than 10 of these large fallen knives at a given time, it was a pretty good time for aggressive investors with a longer time frame to be buying stocks. Although the short-term results could be messy and volatile, those investors hanging on for a few years made an enormous amount of money.

The more prevalent the fallen knives, the more attractive stocks are at the moment. When there are more than 20, it’s a pretty good time to be an aggressive buyer. On the rare occasions where there are more than 50, it’s time to be very aggressive.

Even the more conservative buyers of index funds have done very well buying stocks when there are more than 50 large cap fallen knives available. Those who uses our private equity-like approach to buying stocks have done even better, but no matter what strategy you are using, tracking fallen knives gives you a pretty good indication of the current state of the market.

I am going to keep working with the fallen knives data set to see what additional clues or strategies we can utilize to help us make big money in the markets in the years ahead.

If I see any “knives” falling sharply, you’ll be sure to find out about them by signing up here.

For now, it’s worth knowing that as of Fridays close, one large cap stock has become a “fallen knife” for the first time since June of 2016.

To the Max,

Tim Melvin

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