Are Falling Knives Worth Catching?

If your favorite retailer threw a surprise 50%-off sale, you might well be in your car before you read the rest of this sentence. But when stocks go on sale, there's usually some bad news that prompted the move. That can make it a lot harder to decide whether newly cheap shares are actually a bargain or something has fundamentally changed about the company that justifies a lower valuation.

Green Mountain Coffee Roasters (NAS: GMCR) saw its shares lose nearly half their value yesterdayafter a truly colossal sales miss and cut in future guidance Wednesday night. Although revenue jumped 37% and adjusted earnings rose by 33%, the results came in well short of what investors had expected. Moreover, the big drop in the growth rate for K-Cup sales shocked everyone.

On its face, the reduction in earnings expectations for 2012 from as much as $2.65 per share to a range of $2.40 to $2.50 per share doesn't look that bad. But more important than the numbers is the lack of confidence that investors now have in the company's ability to make predictions about its performance. Even company management admitted to being stumped by the results.

The obvious question is whether bottom-feeding investors here will be rewarded. For some perspective, let's look at several examples of similar moves from other stocks and how their investors fared.

(NAS: NFLX) Netflix suffered not one, but two big one-day drops. Last September shares fell 19% after the company cut its subscriber count forecast following its big move to separate DVD and streaming services, which resulted in a 60% price hike for those who hung onto both services. Then, in October, when the company actually reported a big drop in subscriber counts, the stock plunged again, losing 35% of its value. At that point, the stock hadn't quite hit bottom, but it subsequently rallied before giving back ground again more recently. Now it trades at about the same price it did after the October drop.

One lesson to learn here is that when a stock drops after a potential future problem arises, you may get a further drop when that problem actually comes to pass. Only after all the bad news in a stock comes out should you expect a true bottom. In Netflix's case, nibbling at the first sign of problems turned out to be premature.

(NAS: RIMM) Last September RIM plunged almost 20% after announcing a huge drop in sales that essentially confirmed the ongoing loss of its strength in the smartphone market. Below $24 per share, the stock was near its lowest level in five years.

The problem is that nothing has really changed at RIM since then, and as a result shares have lost another half of their value. The simple lesson here is that without a viable turnaround opportunity, falling knives can keep falling.

(NAS: DNDN) When Dendreon got its Provenge treatment approved, everyone thought it would be a blockbuster. Yet the stock lost nearly two-thirds of its value in one day last August when the company gave up on its sales forecast for the drug. Dendreon blamed reluctant doctors who couldn't count on reimbursement payments for the expensive treatment.

Since then, shares have bounced around in both directions and now trade close to their August levels after the drop. But some of the poor performance comes from prospects of competition.

(NAS: SHLD) The stories above haven't had a happy ending yet, but Sears may provide a ray of hope. Last December, Sears shares lost a quarter of their value when the company announced it would close between 100 and 120 stores after a horrendous holiday season. Yet now shares are 75% higher despite a big drop yesterday.

What's the difference? Some analysts are just as skeptical of the moves Sears has made as they were of RIM and Netflix before it. But CEO Eddie Lampert's strategy of selling off real estate and spinning off some of its divisions seems to have given investors confidence that even if the Sears retail concept fails, there's still value in the shares.

Whether Green Mountain will rebound like Sears, flatten out like Netflix, or keep plunging like RIM is impossible to predict with certainty. But overall, experience shows that trying to catch falling knives is a lot harder than you may think. For every drop that turns out to be the bottom, you'll find others that prove to be just a single step in a much broader plunge. As tempting as cheap shares can be, you should keep your emotions in check and rationally appraise whether a big stock-drop is truly an overreaction, rather than just the first sign of an ongoing problem.

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At the time thisarticle was published Fool contributor Dan Caplinger has learned a lot of falling-knife lessons the hard way. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter here. The Motley Fool owns shares of Dendreon. Motley Fool newsletter services have recommended buying shares of Netflix and Green Mountain Coffee Roasters, as well as creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy juggles with the best of them.

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