Catching falling knives is a dangerous game that's only suitable for those investors who have a high risk tolerance. That said, buying an unloved stock can be highly lucrative if your thesis is proved right and management turns the ship around.
If you do plan on catching a falling knife, you have to do your research beforehand. If you don't properly understand the opportunity, there's a high chance you'll end up with hefty losses.
Leading emerging markets fund manager Aberdeen Asset Management(LSE: ADN) has fallen on tough times recently. Deteriorating investor sentiment towards emerging markets and a backlash against high-fee, poor-performing actively-managed funds has seen investors rush to exit the group's products. At the beginning of February, Aberdeen reported its 15th consecutive quarter of fund outflows. The company reported assets under management of £302.7bn at 31 December, down 3% from £312.1bn on 30 September last year.
As outflows have accelerated, shares in Aberdeen have lost nearly half their value since the beginning of 2015 and even after these declines, they don't look to be that attractive on a valuation basis. Based on current City estimates, shares in Aberdeen trade at a forward P/E of 13.4 and earnings per share are set to fall 3% for the year ending 30 September 2017.
Nonetheless, I believe Aberdeen could be a great long-term investment despite current headwinds.
The group has been around for more than three decades and its asset managers have a wealth of experience. Management has promised £70m of cuts over the next few years to boost profit margins and this cost diet may also spur a reorganisation of the business to better cope with the changing face of asset management. This is where Aberdeen really needs to change to keep up with the shift to low-cost passive investing. It looks as if management is aware of this trend, but it will take time for the business to convince customers it has changed.
When the transformation is complete, funds should flow back to the group and earnings should start to grow again.
The best in the world
Rolls-Royce(LSE: RR) is another falling knife I would catch. The reason why I like Rolls is the company's leading position and expertise in the aerospace market. While the firm is grappling with short-term headwinds, most of its revenue comes from long-term engine maintenance contracts, and it's here where the value is to be found.
At the end of 2016 the firm reported an order book of £80bn and based on last year's total revenue figure of £14bn this backlog locks in just over five-and-a-half years of sales. This gives Rolls a clear runway for future performance.
However, it has its problems and after five profit warnings, it's clear why some investors are not willing to trust the business anymore. But the company is slowly dealing with these issues. Costs are coming down across the group and the SFO bribery investigation has now been settled. Sales are still under pressure thanks to a lack of spending from oil and gas customers, but it is expected capital spending in this market will pick up again during 2017 for the first time in three years.
With Rolls it pays to look past the firm's near-term problems to future growth.
Not suitable for everyone
Catching falling knives is a risky business that's certainly not suitable for every investor and it's one of the major mistakes beginners tend to make.
With this being the case, to help you streamline your investment process, realise and understand the most common investor mis-steps, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.
Rupert Hargreaves owns shares of Rolls-Royce. The Motley Fool UK has recommended Aberdeen Asset Management. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.