How to Avoid Losing Money on Tech Stocks
Investor psychology is a fascinating topic because it shows precisely why 95% of humans can’t beat the market, even when they dedicate their entire lives to that pursuit. Imagine that. A portfolio manager spends their entire life pretending to be someone they’re not. That’s what actors do, but at least they end up with the best choice of mates as opposed to spending their lives trying to justify their own existence.
We recently read that if you’re down on a position you should pretend like you don’t own the stock and then evaluate its merits by seeing if you can recommend it to others. Try that sometime. It’s literally impossible to do, which is why we don’t recommend stocks in the first place. What they might have meant is wait until you’ve accumulated so much paper loss that you really don’t care anymore. That’s kind of where we’re at with Invitae (NVTA) as we see today’s price flirt with $5 a share after we paid an average of $25 a share for our position.
Losing Money on Tech Stocks
YouTube is riddled with videos talking about making money on tech stocks, but few videos talk about how to avoid losing money on tech stocks. That’s because such topics are boring. Nobody wants to hear a lecture on how diversification can protect against losing money in the stock market, but they darn well should. Here’s why.
Putting Paper Losses Into Perspective
We tell our readers over and over not to sweat the paper losses, and one way to make sure you don’t is by limiting the amount of capital you put into any given stock. That’s what we did with Invitae. If we take the total amount of cash we used to purchase shares of Invitae and divide that by our total assets under management (AUM) based on its mark-to-market value today we get about 0.75%. That amount of capital is the maximum we would ever invest in any tech stock. Even if Invitae hits the skids harder than Amy Winehouse, the maximum amount of money we stand to lose is less than 1% of our total capital. That made us curious about which positions we’re holding with the most exposure. Our top four holdings based on weighting across all asset classes are the dividend growth investing stocks seen below:
- Johnson & Johnson (JNJ) – 2.66%
- Archer Daniels Midland (ADM) – 2.60%
- Automatic Data Processing (ADP) – 2.44%
- Exxon Mobil (XOM) – 2.43%
With the exception of perhaps Exxon Mobil, none of the above companies are going away during our lifetimes. We didn’t overweight JNJ, they just happen to rise to the top because they’re probably one of the best stocks you could ever own. As for ADM and XOM, they’re just enjoying the commodities boom. We’re not sure why ADP is doing so well because, frankly, we don’t spend much time looking at our 30-stock DGI portfolio. That’s the best part of the strategy. Set it and forget it.
Let’s get back to talking about Invitae and the psychology of our paper losses. We don’t actually lose anything unless we sell, the company goes bankrupt, or they’re acquired at a price that’s less than our cost basis. Let’s talk about each of these three scenarios.
When to Sell a Stock
Tech investors buy stocks for growth. Dividend growth investors buy stocks for their growing streams of income. If either of these attributes start to wane, then you would consider selling a stock. For dividend champions, it’s easy to set a simple rule. If a company stops growing their dividend, you sell it. For tech stocks, waning revenue growth may be more difficult to quantify. If growth stalls for several years in a row and management’s plan to address that stagnation (they better have one and actively talk about it) doesn’t come to fruition, then that might be a good time to sell. Fortunately, we haven’t had this problem come up yet, but we have had to sell because our thesis changed.
Throughout the time we’ve been publishing our tech stock portfolio to Nanalyze Premium subscribers there have been several instances where our thesis changed and we exited a position. One was when the short report came out on Berkeley Lights and we decided to exit based on a small set of points raised by the short seller. It was obvious the company wasn’t going to hit their growth targets and they failed to acknowledge that. After we sold, they missed their revenue guidance and the CEO was shown the door. That decision turned out to be the right thing to do, at least based on the outcome so far. Exiting at a loss helped us avoid a much bigger loss. These are never easy decisions to make, which is why you need to enter new positions with absolute certainty and strong convictions. Only investing in quality businesses also helps you avoid the bankruptcy problem.
Avoiding The Bankruptcy Pitfall
You can avoid the bankruptcy problem by only investing in quality companies. That’s where two of the most important rules in our tech investing methodology come into play.
First, we never buy stocks unless they have meaningful revenues which we define as $10 million per year. Oftentimes, the cheerleading wankers will come around touting their latest pre-revenue sacred cow and falsely claim, “well if you only invest pre revenue you’ll miss out on the Teslas of the world.” The year Tesla had their IPO, 2010, they had revenues of $116.7 million compared with revenues of $111.9 million reported in the prior year. We’ve lost track of how many turds we’ve flushed down the loo by not investing in any pre revenues teams-with-dreams. Don’t do it.
Second, we don’t invest in companies with a market cap of less than $1 billion.
That cutoff number is arbitrary but at least have one and stick to it. Small companies enter a “death zone” where getting financing becomes more difficult and the odds of things going pear-shaped increase. By only investing in larger quality businesses with meaningful revenue growth, you significantly increase your chances of not holding a stock that goes to zero. But there’s one other thing you need to consider.
A Forced Exit
There’s one last scenario to discuss which is what happens when a stock that you’re holding gets acquired for a price that’s attractive to some investors but not others. For example, what happens if a firm offers to acquire Invitae for $15 a share right now and they accept the offer? That’s a +300% gain for shareholders who just invested in the firm and a locked-in loss of 40% on our position. We had a similar situation last year when Blue Prism was acquired by a private equity firm. Though the loss wasn’t anywhere near 40%, it still resulted in a negative return on investment. It’s a situation that can’t be avoided, but still needs to be considered nonetheless.
Some Lessons on Risk
When you’re a young male, you spend your money on alcohol, drugs, fast cars, fast women, and the rest of it you waste. So, unless you’re born with a golden spoon in your mouth, you’ll be middle-aged when you finally accumulate a decent amount of capital. You’ve now realized that the get-rich-quick FOMO YOLO rubbish being peddled by some guy on YouTube with a Ferrari in the background isn’t the road to wealth. Wealth is accumulated by living below your means, investing money every month, and not taking excessive risks. As you can see with our Invitae example, we’re not losing any sleep at night over the paper losses in our tech stock portfolio. At the same time, we want to avoid situations like Invitae because it means we significantly overpaid for an asset. Some lessons learned:
- We set a limit on the maximum amount of capital to throw at any given stock. It’s easy enough to lower our cost basis tomorrow from 80% to 40% by investing another 0.75% of our capital, but we always stick to the rules.
- Invitae isn’t the first position we’ve been this deep in the red on, and it won’t be the last. Being able to reflect on how we feel when faced with paper losses will help us weather future storms.
- Our simple valuation ratio cutoff of 40 may have been too rich. Other subscribers who used values of 30 or 20 have fared much better.
- When ARK talked about how backing up the truck on Invitae in the mid-teens was a no-brainer, maybe we gave that more credibility than we should have when moving to top off our position. We should practice what we preach – never try to ape an active manager.
Here’s something to consider for anyone holding a stock that’s underwater at an 80% loss or more. When the dot-bomb crash of 1999 happened, tech stocks were decimated. Even names like Intel and Oracle plummeted more than 80% from their peak, and only returned to those levels after 10 years has passed. Whatever money you’ve invested in tech stocks shouldn’t be money you need to withdraw anytime soon.
The same people that worshiped the ground Cathie Wood walked on are now queuing up to sling mud at her because that’s the nature of human beings. ARK Invest loves risk like a fat kid loves cake. Risk equals volatility, so why is everyone so shocked when they end up holding positions that are 80% under water? Why should any tech investor be shocked to see such paper losses? Volatility goes both ways, yet investors only seem to notice it when stocks are falling. Tech investing requires a steady hand in the face of dire losses. The only reason you should fear a paper loss is if you didn’t invest in a quality company to begin with.
Tech investing is extremely risky. Minimize your risk with our stock research, investment tools, and portfolios, and find out which tech stocks you should avoid. Become a Nanalyze Premium member and find out today!