Shock drop alert: What goes down can go down some more

I remember myself once queuing up early one morning to buy a $500 "leather" chair on sale for $50. Clearly, persuading someone to buy something that's had a big fall is one of the most powerful sells in the world. Ask any retailer or stock broker. But in "shock drop stocks" the buying is confusing. Yes you can understand the traders wanting to play around, volatility and volume are their lifeblood. It doesn't matter if it's BHP or cabbages.

But what about the people who woke up the morning of the shock drop with absolutely nothing on their mind yet, presented with bad news on a stock they don't hold and probably don't know, they suddenly decided to, of all things, buy.

Now you could appreciate it if they were all expert value investors who could instantly calculate value and compare that with the fallen share price, but I doubt they are. I might be guessing here but I have an inkling that people who buy shock drop stocks are in fact operating under one terminally flawed yet irresistible assumption that: "It's fallen a lot, so it must go up."

If that's what you think then you might like to read the following.

Telstra had a profit warning with its results last August. On that day, 338 million shares traded and the share price fell 9.5 per cent from $3.25 to $2.94. Three months later and it had fallen another 13 per cent.

Downer EDI had a profit warning last June and fell 27 per cent in a day on the biggest volume in seven years. It fell another 27 per cent in the next month.

Alesco had a profit warning last March. It fell 31 per cent on the day and in the next four months fell another 22.4 per cent.

CSL fell 7.2 per cent in a day last April after some comments from its US competitor, Baxter. A month later it was down another 10 per cent.

In February last year Gunns fell 26 per cent in a day. In the next three months it fell another 60 per cent.

In November last year Hastie Group fell 12.2 per cent in a day on a profit warning. In the next month it fell another 34 per cent.

In February last year Roc Oil fell 28 per cent in a day on a profit warning. By June it had fallen another 28 per cent.

In March last year Sigma Pharmaceuticals fell 48 per cent in one day on a significant profit warning. It fell another 10 per cent in the next month.

Yes there are some exceptions (Computershare, Crane Group and Sonic Healthcare), but on balance buying a shock drop stock is a high-risk trade, especially on the first fall. Here's why:

Stocks fall over for a reason and it's not often because they have been misunderstood for just 24 hours, after which they miraculously regain their pride.

The institutional investors react a bit slower than you do and they have a lot more stock to shift than you do, and it takes time.

A US study once established that when a company has a shock

price movement (in either direction) the stock tends to trend in the

same direction for the next nine days.

As any technical trader will tell you, possibly the worst advice you can ever get is "It's down X per cent, you have to buy!"

Finally it takes three times as long to build confidence in a share price as it does to lose it. Big disappointments linger in the price. So there's rarely any rush to buy.

And to prove the point, that $500 leather chair turned out to be plastic crap, I didn't actually need it, they are still on offer for $50 and I was left with that uncomfortable feeling of having been royally done over. Same thing, really.

Marcus Padley is a stockbroker with Patersons Securities and the author of sharemarket newsletter Marcus Today.

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