I received a question : NIIT tech has dropped from 100 to around mid 50s. Is it a falling knife which one should avoid ?

 I have written a post on the above topic earlier. So the point is how does one avoid a falling knife scenario ? In other words when it is wise to increase the holding as the stock price is dropping versus avoid averaging down.
 
Two factors
I would answer the above question based on two key factors one should keep in mind when purchasing a stock. The first factor is the intrinsic value of the stock. One should have decent idea of the Intrinsic value range of a stock. If the stock price is dropping and the stock is more undervalued now, one can look at increasing the holding.

The second factor is position size or risk management. Personally when I am looking at a stock, I make a decision on whether the stock would be a part of my core portfolio or the cheap-graham portfolio. Once I have made that decision, I have pre-set limit on the position size. One can have an amount or percentage of the portfolio – position size. I typically start off with a 50% position (50% of the full position) and keep adding as the stock price drops.

Once I have built a full position, I will not add to the position even if the stock price is dropping. This is the key to risk management. I regularly check my thesis to confirm if any of my basic assumptions are incorrect and if my estimate of intrinsic value is too high. However I will not add to my position even when the stock price falls. There is no averaging down for me, once I have built a full position

70% strike rate
I have read that most of the top investors typically have 70-80% hit rate. That is 20-30% of their stock picks result in losses, either due to bad luck or incorrect analysis. I don’t believe I will do better than that. I have now started working with an assumption that 20-30% of my picks will fail. In such a scenario, the risk management aspect is crucial. To do well on a portfolio basis, my successful picks should do better than my failures.

What about NIIT tech
In the case of NIIT tech or any other company, my focus is on intrinsic value and not on the stock price. The stock price can get disconnected from the intrinsic value for sometime, but it eventually converges to it.

My own estimates of  intrinsic value for the company have not changed. The current quarter results show a bottom line drop of around 50%, mainly due to forex losses. I do not consider them as core losses (just as forex gains are not permanent gains). I have seen a lot of people get all worked up about forex losses, which does not make sense to me.

Unless the company is speculating on forex (via non effective hedges), I think the forex gains and losses should even out over the period of few years and hence one should be concentrating on the core profits to value the company. As an example look at the results of the airlines such as southwest (in the US). Southwest airlines has been consistently profitable for the last 20+ years. They have had 2-3 quarters of hedging related losses due to oil price volatility. Do you think they have a problem in their core operations?

Anyway, I digress. Coming back to NIIT tech, I have not changed my estimate of intrinsic value and I have already built my planned position. As a result even if the price drops, I will not add to my position to manage the risk (if I am wrong about NIIT tech).

Management issue
However if you believe that in light of the satyam episode, you cannot trust the management , then the only course of action is to exit the stock.

Personally, the moment I lose faith on the management and cannot trust them, I will exit the stock irrespective of the loss I have to take on my position.

As an aside, my previous post was in jest. I received a few personal emails ‘challenging’ my prediction and one guy asked me why I did not predict the level, if I knew the time . I have no clue where the market will be in the future. However if you want to pay me, I can guess for you 🙂

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