The stock market.

What a crazy place!

Anyone who read last Monday’s article would have seen that I recently purchased £222 worth of Dignity Plc shares.

Well, these went on to crash and burn 50%.

I must be a genius, right? It takes something special to turn £222 to £111 in just a few days.

Luckily, my portfolio is HEAVILY diversified and the £111 loss I suffered is barely a scratch in my portfolio that’s now approaching £17,000.

Anyone wanting to know exactly what happened to Dignity shares should click here for my live reaction of the 50% drop!

Having just experienced the pain – this seems like the perfect time to talk about falling knives.

The term “catching a falling knife” is when an investor reacts to a declining share price by mistakenly thinking that all the bad news of a stock/sector has been priced in and buying a stock they deemed undervalued expecting a recovery over the longer term.

Last week, I caught a falling knife.

Here’s how I messed up.

Whenever I investigate a company there are two things I generally look at immediately – The market cap and the price to earnings ratio.

These two measurements are related and both hold a clue to how I got burned last week.

Let me show you how.

To illustrate this, let us take a look at two retail competitors, Next Plc and ASOS Plc.

Next currently has a market cap of £7.13B

ASOS, on the other hand, has a market ap of £5.6B

To the newbie investor, it may seem that Next and Asos are of similar scale.

But, if we look at the revenues of both companies we can see that Next is substantially larger.

Next’s 2017 Total Revenue came in at £4,097m with ASOS way behind with Total Revenue of £1,924m.

Here we begin to see how disjointed from reality and business fundementals the stock market can become.

This is why I like to think of the price to earnings ratio of a stock as a indicator of how jointed/disjointed a stock is from the underlying current fundementals of a stock.

Reasonable p/e ratios of 10-18 for the FTSE are my sweet spot. Anything lower may indicate serious underlying problems while anything over may be overvalued.

You see, the key difference between the valuation of Next and ASOS stock comes at their price to earnings ratio.

Next boasts a p/e ratio of a touch over 11 with ASOS trading at close to 89.

That means investors purchasing these stocks today would be paying £11 for every £1 of Next’s earnings and £89 for every £1 of ASOS’s earnings.

But here’s the mistake I made.

The p/e ratio of a stock is based on a stock’s current year’s earnings (ttm – trailing tweleve months).

When I bought Dignity at a 15 p/e I thought I had a bargain!

Here was a solid stock in a recession proff industry trading at historically low valuations.

Sure, competition was heating up but I felt the risk had been priced in to the stock and that it was “worth rolling the dice” regardless of the competition risk.

After all, I was reassured by the words management – they had a statement in November regarding competition and were confident that their pricing stratergy at the time was generally fit for purpose.

BUT – it seems that management really didn’t have a grasp on how much the competiton was heating up, and, in response to falling customer numbers decided to slash their funeral package prices for next year by 25% OUCH!

What? Seriously, in three months things got that much worse?

This folks, is what we call a falling knife.

Just when I thought the bad news was priced in, management dropped a bombshell!

Here, I’ll introduce you to another little phrase – “Value trap”

Let me explain;

Dignity’s 2017 earnings are on track for £1.19 per share and this was the figure used to caluclate the firms p/e raito when I purchased shares, but, next year, after the drastic cuts announced by management Dignity’s earnings per share are forecast to drop to just 88p for 2018/19.

Given these new estimates I purchased Dignity shares at a forward p/e ratio of 21.

21 P/E for a company in an increasingly competitive field?!?!?!

? 

I got hoodwinked by managements smooth talk for sure and should have stayed well clear until the competition dust had settled.

I can’t say I wasn’t warned and will take everything a company’s management says with a massive grain of salt from now on. I should have stuck to the fundementals and sector trends.

DOH!

What lessons can we take from this investment?

In reality, Dignity’s decline has been a pretty cheap lesson in the grand scheme of things.

Here’s a 50% loser amongst triple digit winners that I invested a lot more money into.

MSFT is up 120% since I bought in, MCD 112%, Apple 91%.

These were all £500 buys.

Luckily, one of my investing rules saved my bacon when it comes to Dignity.

Let me explain – my average investment in a single stock is a strict £500.

If I feel really confident and the stock is meets all my ‘Safe buy’ criteria I’ll go in up to £1,000 as is the case with Unilever and Next. (£800 and £900 respectively)

As Dignity was a small cap stock that had significant risk due to debt and competition, a half position was more sensible.

This is exactly why I arrange my portfolio into a house.

Foundations, Walls, Auxillary.

As Dignity was in my Auxillary it was always going to be a riskier play.

As for Dignity’s future – I’m going to hold and see how things go.

In summary, here are the key lessons I learnt from this investment and my adjustments from here on.

  1. Take EVERYTHING management says with a HUGE grain of salt.
  2. Fundementals and industry trends don’t lie.
  3. I should continue to organise my stocks under the ‘dividend house’ model as this saved me from a material loss.
  4. I should look for companies with wider and more secure economic moats and be wary of a company that’s considering moderate price cuts – this may be a sign of harsher price cuts in the future (as was the case here).

Before going, I have a small favor to ask of you.

At Frugal Student, I hope that you enjoy tracking my portfolio and appreciate the fact that I don’t shy away from any investing mistakes or hide anything from you as a follower.

I’m a full-time student and running this blog isn’t easy.

I don’t earn a penny from this blog and will never run ads on this site – it’s lame and kills the browsing experience.

So, I ask you, if you enjoy my content if you could introduce just one friend to my blog it would mean a lot!

Happy investing.
Lewys

PS: Any questions just drop a comment or E-mail me at – Lewys@frugalstudent.co.uk