Buying when a stock is plummeting takes guts, but it can be exceptionally profitable when it works out.

Just look at the opportunities in the last year. Fairfax Financial (NYSE: FFH ) , Career Education (Nasdaq: CECO ) , and Champion Enterprises (NYSE: CHB ) all hit multiyear lows last summer. With Fairfax, people were worried about the insurer's exposure to hurricanes. With Career Education, the entire for-profit education industry was in the dumps amid a stream of scandals and increased competition. With Champion, investors panicked over the state of the manufactured housing market. Since then, these stocks are up an average of 90%.

The long-term returns can be even better. If you bought Royal Caribbean Cruises (NYSE:RCL ) after its sharp post-9/11 drop (when the outlook for travel looked bleak), you'd have a more than 300% gain. Elan actually provided two opportunities in the last five years, dropping from $40 to $2 over a few months in 2002, then from $27 to $3 in early 2005.

So, there's money to be made from catching falling knives. The challenge is doing it without losing a finger.

1. Accuracy over quickness

 

The first rule of catching falling knives is that accuracy is more important than quickness. Stocks fall because of bad news. That bad news will typically take some time to absorb, so you usually have time to evaluate the investment. And this is one time you shouldn't rush -- it's important to understand how the news will have an impact on the outlook of the company.

Is it just a one-time event that nobody will remember in a year, or does it affect the business more substantially? Is the company's competitive position affected? Or, even worse, is its liquidity? You should be looking to catch knives that result in shares being cheap, but don't substantially affect a company's long-term outlook.

An ideal knife to catch would have been Merck (NYSE: MRK ) below $30 back in October 2005 at the peak of the Vioxx uproar. Merck's competitive advantage was in its ability to create, acquire, and commercialize drugs, and this advantage was unlikely to be affected by Vioxx. Its balance sheet was solid, with $10 billion in cash. Vioxx was bad, but clearly not a company-killer, and now the stock is above $50.
 

2. Wear gloves

 

When you're catching knives, prepare for the worst. Often, a stock will continue falling after you buy it. You should plan for this scenario. One way of doing this is by dividing your money into three piles, and buying in thirds. Buy the first third at a good price. If the stock continues to fall, buy the next third. If it drops once more -- and the stock seems more attractive than ever -- buy the final third.

My rule of thumb is to buy a big enough initial position that I'm content if the stock recovers, but a small enough position that I'm even happier if it goes down and I can buy more at a cheaper price.