Why We Only Buy Tech Stocks That Are Unicorns

One problem with mainstream financial pundits is their tendency to ball all risky tech stocks into a single category. That’s not a good way to manage risk. You cannot equate a pre-revenue SPAC with an enterprise software-as-a-service (SaaS) IPO that has double-digit revenue growth coming from some of the biggest companies in the world. In the same manner, a $100 million company with double-digit revenue growth is not the same as a $10 billion company with the same revenue growth rates. In the world of tech stock investing, the size of the boat affects the motion in the ocean.

Size Matters

The research is crystal clear. Small-cap stocks are more risky than mid-cap stocks and large-cap stocks. While high risk can equate to high returns, small caps require us to sacrifice more risk per unit of return than mid-caps or large-caps. The below diagram shows the Sharpe ratio for each class of stocks – small, mid, and large (bigger numbers are better):

Credit: John Hancock Investment Management

The simplest way to think about the Sharpe Ratio is that it measures the rewards you received for the risks you took (also called a risk-adjusted return). Think about investing all your money in an FDIC-insured savings account and getting 0.065% a year return on your money. Your risk may be next to nothing, but the returns are as well. Sharpe ratio is all about taking on as little risk (volatility) as possible in exchange for the maximum amount of upside. Historically, small caps have been seen as having a consistently lower Sharpe ratio than mid and large-caps stocks.

Reducing Size Risk

Tech investing is incredibly risky, to begin with. Instead of constantly trying to find the next Microsoft, why not spend time trying to find the next Bind Therapeutics? The first rule to avoid getting ripped off is don’t invest in companies run by deep-voiced, crazy-eyed sociopaths. The second rule is don’t invest in pre-revenue companies. And the third rule, one that also helps us sleep well at night, is don’t invest in companies unless they’re all grown up. As described in the The Nanalyze Disruptive Tech Methodology, we only invest in companies with a market cap of one billion dollars or higher. Today, we want to talk about why that simple-sounding rule isn’t so straightforward.

A Market Cap Cutoff Rule

A market cap (MC) cutoff rule simply says that we don’t buy stocks unless they exceed a pre-determined market cap value. (Market cap is share price multiplied by shares outstanding which is a simple way to measure the value of a company and compare it to other companies.) So, how do we determine what value our market cap cutoff should be set at?

Given the pedigree of our research team, it seemed only natural to look at how index providers calculate MC cutoffs. When global index leader MSCI calculates MC cutoffs, they actually do it dynamically, based on the entire universe of stocks they’re looking at. In other words, it’s a moving target.

Market cap cutoffs can be complicated – Credit: MSCI

We like to keep things simple and stick with a nice, round, easy-to-remember number. What’s more important than picking the right number is having a process in place that we can use to qualify companies as “investable.”

The Unicorn Rule

Since most firms consider small-cap companies to be anything under $1 to $2 billion, we’re in the right ballpark with an MC cutoff of $1 billion. It’s a number that’s easy to remember, and it also has relevance in the startup world as well.

In the parlance of venture capital investing, a company with a valuation of $1 billion is considered a unicorn. Valuation and market cap are similar, but not the same. A valuation is simply the value ascribed to the company during the last funding round. A market cap reflects the valuation the market gives a company in real time. So, we can refer to our MC cutoff rule as our “unicorn rule.” In order to understand how our unicorn rule works, let’s look at a real-world example.

CELLINK – A Market Cap Cutoff Example

The last time we looked at 3D bioprinting stock CELLINK was back in April 2019 when they had a $257 million market cap. Since then, the company had a 4:1 stock split, and the market cap has now breached our $1 billion market cap threshold putting them squarely on our radar. (As of today, CELLINK‘s market cap is nearly $1.6 billion.) Let’s assume that after writing a follow-up article, we decide to open a position in CELLINK. This begs some questions about our arbitrary market cap threshold of $1 billion.

What happens if tomorrow we find out The Rona has morphed into something with a mortality rate 10X the current USA mortality rate of 1.7%? (Data taken from John Hopkins.) Consumerism can’t grow much if the population isn’t growing. Even the weekday wankers over at Robinhood would realize this, and the equities markets would understandably plummet. If that happened, the market cap of CELLINK may fall below $1 billion. Just because CELLINK is no longer above our pre-determined MC threshold, doesn’t mean we wouldn’t buy shares if they dipped. This is why we’re viewing the MC cutoff as a knock-in option.

knock-in option is a type of contract that is not an option until a certain price is met. So if the price is never reached, it is as if the contract never existed. However, if the underlying asset reaches a specified barrier, the knock-in option comes into existence.

Credit: Investopedia

Once triggered, we revisit the stock and make a decision as to whether or not we want to go long.

Hype or Growth?

One thing we need to consider is whether a company is exceeding a $1 billion market cap because of growth or because of hype. To determine that, we can look at the time it took for a stock to reach the magical $1 billion threshold. If the stock price spikes over a short period of time on no news, then it’s likely being driven by hype. The last thing we want to do is start buying a stock at peak hype. However, if it slowly gains ground over time accompanied by strong revenue growth – as CELLINK did – then there’s a justification for reaching that $1 billion valuation. One way to measure the time it takes would be to consider the following:

  • Number of days it takes to move from $250 MM to $500 MM
  • Number of days it takes to move from $500 MM to $750 MM
  • Number of days it takes to move from $750 MM to $1000 MM

In all cases, we start counting days once the closing price exceeds our market cap threshold. We’ll avoid the complexities around intra-day price movements and simply look at closing prices. Here’s how many days it took for CELLINK to reach our three market cap milestones on its way to becoming a $1 billion company.

  • Days from $250 MM to $500 MM382 Days
  • Days from $500 MM to $750 MM441 Days
  • Days from $750 MM to $1 billion77 Days (effective 7/12/2020)

It took roughly 30 months for CELLINK to move from a $250 million company to a $1 billion company. Only last week did we discover that CELLINK had surpassed our $1 billion threshold over the summer, an event that went unnoticed because we were too busy building our premium subscription offering. We can learn a few lessons here.

  • It takes time for a company to achieve a $1 billion market cap through normal growth, not hype. We don’t know what the optimal time is, but we may be able to come up with some sort of minimum rule here.
  • Because we’re running lean at the moment, we didn’t have anyone checking the market cap for stocks like CELLINK so we could be alerted once they surpass a $1 billion threshold. This would have provided us with the opportunity to begin accumulating a position.

After we finish building and deploying our premium newsletter for Nanalyze Premium annual subscribers, we’re also going to look at how we can set up some alerting functions for subscribers as well. If a stock price fall by a certain amount, or a stock suddenly becomes investable, we’ll be able to let you know the day it happens. Stay tuned.

As for CELLINK, it’s been almost two years since we wrote about them – 22 months to be exact. We’ll plan to take a fresh look at what they’re up to and see how a position in the company would complement the other 26 stocks in The Nanalyze Disruptive Tech Portfolio. We’ve added that task to our research queue and would expect the new CELLLINK article to come out within the next several weeks.

Conclusion

Over the past decade, we’ve looked at hundreds of examples where small stocks blew up. Typically, they’re OTC stocks, which shouldn’t come as a shock to anyone. Lately though, we’ve been coming across a lot of stocks traded on exchanges across the globe with minuscule market caps. Our easy-to-understand unicorn rule helps us avoid stocks where size becomes an excess risk we want to avoid.

Tech investing is extremely risky. Minimize your risk with The Nanalyze Disruptive Tech Portfolio Report to find out which tech stocks you should avoid. Become a Nanalyze Premium member and find out today!

2 thoughts on “Why We Only Buy Tech Stocks That Are Unicorns
  1. Your system doesn’t know me as a premium subscriber by denying premium access. Thanks in advance for fixing this.
    Bill Blair Jan. 24 2021.

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