The Nanalyze Disruptive Tech Investing Methodology
Our mandate is to research disruptive technologies for an audience of retail and institutional investors while never assuming anyone has prior knowledge of the subject matter. Since we now sell premium content as a subscription service, we think it’s important to define our approach to investing in disruptive tech stocks which emphasizes risk management and diversified asset class allocations. Understanding how we research companies helps our readers understand what we do behind the scenes. More importantly, it allows us to scale our service offering as we get more financial support from our subscribers. If you’re going to pay for something, you ought to know what you’re going to get.
Risk-Averse Tech Investing
There are no shortage of pundits out there pointing investors to the latest tech stock story. Everyone will tell you what tech stocks to invest in, but very few will tell you what tech stocks not to invest in. That’s where we distinguish ourselves from most other firms out there. Additionally, we believe that teaching people how to become better investors by looking for red flags will serve them better in the long run. Every conclusion we arrive at is presented along with the logic and research that led to it. When we invest in a stock, we’ll walk you through that process too. We’re not a “stock picking service.” The research and insights we publish are meant to supplement your own decision making process.
Publishing Without Bylines
You may have noticed that we publish under a single byline – Nanalyze. This forces the reader to always judge the content on its own merits; we want you to focus on the message and not the messenger. It also forces us to have a consistent approach to producing content and researching. Rest assured, we have writers and researchers working across the globe to produce content.
We’re serious about investing, but we don’t take ourselves too seriously. For instance, we often take the piss out of MBAs, but those are the same people who produce our premium articles. We avoid employing domain specialists because we believe they assume too much prior knowledge when writing about a topic. We always assume the reader has no previous knowledge of the topic, and cater our message to first-time investors. We evaluate stocks, ETFs, alternative assets, and other investment vehicles that expose investors to 12 disruptive technologies and more than 70 related themes.
When evaluating stocks for premium subscribers, we first start by analyzing their SEC filings.
Analyzing the SEC Filings
Warren Buffet is said to only invest in companies he fully understands. The same can be said for every company we write about. The best way to understand a company is to skip the glossy investor decks and go straight into their SEC filings. For example, the S-1 that’s published when a company files its initial public offering (IPO) contains dozens of pages to pore through for details about its financial health, business strategy, and industry risks. We frequently write about IPOs using nothing but the S-1 filing, producing an entire 1,500-page article that just contains the insights and useful information with all the noise filtered out.
Unfortunately, more startups are now using special purpose acquisition companies (SPACs) to go public. SPACs don’t require an S-1 filing. In these cases, we immediately start looking for red flags. The sooner they can be found, the sooner we can move on to other opportunities. It’s similar to the process that hiring managers use to evaluate large numbers of candidates for a single role. We’ve looked at more than 40 disruptive tech SPACs and only invested in a few. As time goes on, SPACs are becoming even riskier and most have corrected sharply leaving us to ask, Now That SPACs Have Fallen, Are Any Worth Picking Up?
Evaluating Disruptive Tech Stocks
There is no shortage of pundits who will tell you what to invest in. Few will focus on what not to invest in. Tech investing is inherently risky, so we always start by looking for red flags.
Looking for Red Flags
One thing we’re constantly warning readers about are penny stocks (also called over-the-counter, or OTC, stocks) because we’ve seen so many of them go bust. (The exception is foreign stocks.) It’s safe to say that 95% of all penny stocks we’ve looked at are garbage. It all usually starts with a reverse merger where “Bob’s Used Autos” becomes “Blockchain AI Graphene 3D Printing Inc.” Some red flags are as follows:
- The company possesses one patent or a small number of patents that it claims applies [insert your disruptive technology here] to cure cancer and the common cold all at once. These patents are usually acquired in the reverse merger or invented by someone in senior management whose credentials and past successes are heavily touted.
- The company’s marketing materials, financial statements, SEC filings, etc. will focus in great detail on the massive size and amazing potential of the market opportunity. At the same time, there will be few details about how their product can successfully capture revenue from said market application.
- There will be paid “research reports” where a bunch of sycophants set ridiculous price targets based on whatever the company spoon-feeds them. (Always look in the research report disclaimers for evidence of this.)
- There will almost never be revenues which help demonstrate traction and product fit. Oftentimes, you’ll see grant income listed as revenue.
- Many individuals on stock message boards such as the ones found on Investors Hub will suddenly start posting messages touting the merits of the stock. They’ll use phrases such as “load up”, “get on the train”, “the next Microsoft”, “easy ten bagger”, etc.
- Any constructive criticism of the company will be met with accusations of short selling. In fact, short selling OTC stocks is very difficult and rare. And we never short stocks.
- The company will keep announcing partnerships, memorandums of understanding (the legal equivalent of a handshake), and other types of agreements that never actually go anywhere.
- The company will communicate in an overly aggressive manner with shareholders, such as issuing press releases every other day.
- If the stock is listed on a major exchange, don’t assume institutional ownership means what you think it means. (See our piece on What Institutional Ownership Really Means.)
- When the original opportunity does not transpire, the company will then start to identify other application opportunities for its technology
- Oftentimes, you can go back five years in the financials and find previously made promises that were consistently broken.
- Private placements are often used to support the company until the share price completely collapses and the long term shareholders are left holding worthless shares – bag holders.
- And the ultimate sign that a company is up to no good? When their attorneys send us a cease and desist letter.
We’ve covered many companies that raise more red flags than a European football match. As a result, we’ve been threatened countless times over the years by individuals who don’t like it when someone looks at their business with a critical eye. (So some of your premium dollars help us keep a lawyer or two in practice.) Usually the people who behave the most aggressively are the ones who are involved in a coordinated pump-and-dump scheme. A competent management team would reach out to have a discussion instead of making threats. In some cases, the management teams themselves are the problem. Dig a bit into their past and you’ll uncover previously failed companies or associations with other dubious enterprises.
It’s not just on the penny stock exchanges where you’ll find shady companies. We’ve also seen a fair number of companies listed on major exchanges that raise many of the same red flags. For example, most of the largest Chinese tech companies that trade on major U.S. exchanges have complex structures in place called variable interests entities (VIEs) that are a major cause for concern. That’s why whenever we sit down to evaluate any given stock, the very first thing we do is look for red flags. Any company that espouses hiring based on factors except merit is should be viewed with suspicion. We’ve articulated why in our video presentation on How Diversity Damages Shareholders.
The next thing we do is try to understand how pure-play the asset is.
Finding Pure-Play Stocks
We often talk about the “invest in everything with Google” fallacy. This is where finance pundits often list Google as a stock for just about every disruptive technology out there. Want to invest in autonomous driving? Google. Want to invest in AI? Google. Want to invest in AR? Google. In reality, when you buy shares of Google, you’re investing in a company that derives nearly all of its revenues from advertising. When looking at any stock that claims to be involved in something disruptive, we need to see how much of its revenues are being derived from said technology.
What Are The Sources of Revenues?
Even reputable and reliable companies – IBM being one – don’t provide much granularity when segmenting their revenues, so you can’t really tell where they’re making the bacon or just frying fat. Other companies may only have small amounts of revenues tied to a particular technology, but if that number is growing in double-digits every year, it could be quite meaningful. Teradyne’s move into industrial robotics is a good example.
It’s all about making sure that you’re getting exposure to what you think you’re getting exposure to. If there are revenues attributed to a particular technology, they need to be growing at a rate that matches or exceeds what the sector is expecting. If an industrial robotics company hasn’t grown revenues for the past four years but industrial robot installations have been growing at a +22% CAGR, something is wrong. Profitability is optional in the beginning, strong revenue growth is not.
Companies With No Revenues
When a company doesn’t have revenues, you’re stuck with management’s crystal ball forecast that tells you two things: size of the total addressable market and the percentage the company believes it can capture. This means you need to evaluate the credibility of the person making those claims. Renalytix AI is a great example of a company with a master plan and no revenues, but with a leader who sold his last company for $575 million a few years ago and now wants to build and sell another one.
A Blue Ocean TAM
When looking at a stock’s potential, we need to consider the size of the opportunity they’re trying to capitalize on. This is called the total addressable market (TAM), and the type we look for is referred to as “blue ocean.” A couple of INSEAD MBA professors coined the term, and being the MBAs we are, we started using it without even looking up what it meant. Intuitively, it means a total market opportunity that’s so vast you could grow revenues for a decade at a triple-digit compound annual growth rate without even capturing a market share in the double digits. But it’s actually more profound than that. Says Investopedia:
A pure blue ocean market has no competitors. A blue ocean market business leader has first-mover advantages, cost advantages in marketing with no competition, the ability to set prices without competitive constraints, and the flexibility to take its offering in various directions.Credit: Investopedia
In other words, a blue ocean is a market that nobody occupies, that is until some BSD dominates it, Apple probably being the best example. It seems intuitive then, that the early market leader in a blue ocean will likely become the biggest shark.
A Size Rule for Stocks
Smaller companies, in general, are riskier than larger ones. That’s because larger companies have better economies of scale, better access to credit and financial markets, and can often weather market turbulence easier. What’s considered small? That depends on who you ask and when you ask them, as many definitions will vary based on the universe they’re examining.
As of August 2020, MSCI, the leading global provider of international equity indices, considers any company with a market cap less than $5.6 billion small cap, meaning that it carries additional risk due to its size.
We cover many disruptive technology stocks that are at the beginning of their growth trajectory, hence a higher market cap cutoff wouldn’t make sense. Based on our research, we have set our own minimum market cap rule for investment at $1 billion. We’re trying to aim for size and stability and the small number of truly pure-play disruptive technology stocks available on the markets.
While we still scout and cover smaller stocks, we enforce this $1 billion market cap rule only in the case of our own tech investments which can be found in The Nanalyze Disruptive Tech Portfolio. For more information on how we implement our size rule, check out our piece on Why We Only Buy Tech Stocks That Are Unicorns.
Aside from setting a minimum size cutoff, we also want to make sure we’re investing in more “larger” stocks than “smaller” ones as this reduces overall portfolio risk. Below, you can see the target weightings we’ve established for each size category.
Stocks that flow through this funnel ultimately end up in the “mega” bucket where they are then harvested, and the profits used to buy more green shoots. Just remember, The Smaller the Stock, the Bigger the Risk.
A Valuation Ratio Rule for Stocks
We’ve largely avoided valuation ratios until recently because we believe in keeping things as simple and jargon-free as possible. As we continue building our tech stock portfolio, we’ve found the need to compare multiple stocks – especially ones that have only begun trading recently – to see which names appear overvalued. When deciding what valuation ratio to use, we went for “simple and responsive.”
Our simple valuation ratio is as follows:
- Market capitalization / (last quarterly revenues * 4)
Anyone can calculate the above metric by looking up a ticker on Yahoo Finance and clicking once (on the chart to show the latest quarterly revenues). We added the ratio as a data point in our disruptive tech stock catalog, and decided upon a simple rule going forward. We won’t invest in stocks where the valuation ratio exceeds 40. If you want to know why we settled on that number, you’ll need to read our article on A Simple Valuation Ratio for Disruptive Tech Stocks. Just beware of value traps and pay attention to share buybacks and dilutions.
A Weighting Rule for Stocks
There’s an old adage that says you should always let your winners ride. Another adage says you should never be too far overweight a particular stock so as to remain diversified. Our decision to cap weights in our portfolio at 10% isn’t one that comes from rigorous scientific research, but rather something that’s just a nice round number that is more commonly seen across portfolio managers who try to keep their winners from running too far (tech stocks are exceedingly volatile, so such a rule makes sense to have as they can fall as quickly as they rose). When do we start trimming? We’ll leave some room for discretion there. As for the number of stocks in our portfolio, we’ve set a hard limit at 40 stock maximum calculated as follows – (12 categories X 3 stocks + 10% buffer rounded = 40). Further information can be found in our piece titled How Many Tech Stocks Should You Hold In Your Portfolio?
Our Approach to IPOs
We’ll often come across cases where disruptive technology companies are offering their shares to the public for the first time – what’s called an initial public offering (IPO). Investing in IPOs can be tricky.
Many IPOs tend to have a first-day pop – 18% on average – followed by a volatile early trading period that lasts a few days or weeks. That’s based on four decades of data that covers 8,500 IPOs. In order to take the emotion out of our investment decisions and to avoid chasing this price pop, we have established a waiting period forr newly listed stocks before we consider adding them to The Nanalyze Disruptive Tech Portfolio.
Other industry participants, like index calculators and ETF providers tend to include IPOs quarterly with the exception of really large, meaningful ones that are included 10 days of trading (that’s MSCI’s rule last time we checked). We believe three months is not necessary to have a new listing’s initial volatility subside, but 10 days is too short a time frame. That’s why we won’t be buying shares in any IPOs unless they have published a 10-Q or a 10-K. When we do buy shares, we’ll do it over a sustained period of time using dollar-cost-averaging. To learn more about how we go about buying shares, see our pieces on How We Manage Our Tech Stock Portfolio and Buying Tech Stocks in Times of Market Volatility.
Our Time Horizons
We’re investors, not speculators. When we go long a stock, we plan to hold it for at least five years or longer. We invest based on a core conviction that ignores any short-term noise. When a stock dips because of an earnings miss, we don’t fret, we see this as an opportunity pick up shares at a discount. About once a year, we’ll check in to see how a company has been progressing. We identify key metrics to watch such as revenue growth by segment, number of customers, or retention rates for software-as-a–service (SaaS) business models.
Speaking of which, we are particularly attracted to the strength of SaaS companies, especially ones that are industry agnostic. For more information on the topic, please see our piece on The Best SaaS Stocks and How to Find Them.
When the market becomes gripped with fear (as measured by the VIX) then capital dries up and share prices start to plummet. When interest rates rise, the promise of a dollar tomorrow is worth a whole lot less than a dollar today. Companies that don’t have enough cash to weather the storm then need to raise debt at unfavorable terms or sell shares at rock bottom prices. Both scenarios aren’t any good for shareholders. When evaluating survivability we can look at several metrics including gross margin and runway. If you invested in good companies to begin with then you just need to weather the storm. Companies with low gross margins that are bleeding cash become concerning when they have no clear path to profitability. Don’t panic when share prices fall and sell unless your thesis changes. That’s something we cover in our piece on How to Avoid Losing Money on Tech Stocks. It’s especially relevant now that we’re in a bear market, there’s a food crisis, and US/China relations are at an all-time low.
There are quite a few thematic ETFs out there that offer less pure-play exposure than you think after reading their marketing collateral. That’s because there just aren’t that many pure-play stocks for any given tech theme, so MBAs who build the ETF portfolios get a little creative with the category criteria. You’ll often find there can be two ETF providers targeting the same theme but with minimal overlap. This shows how subjective the process of identifying stocks for any given theme can be. When evaluating ETFs, we focus on understanding why each asset has been included.
Because many of our subscribers are new to investing, we believe it is important to constantly emphasize best practices like diversification and dollar-cost-averaging. No matter how compelling you find any given stock, do not invest more than 5% of your assets in it. Think about how few people follow that rule over at Robinhood and why most of them end up losing lots of money trying to “trade stocks.”
The sooner you learn that you’ll never make any money trading stocks, the sooner you’ll be able to become an investor. It’s about time in the market, not timing the market. If 95% of all financial professionals out there tasked with beating the market aren’t able to, why do you think you’ll fare any better trying to trade stocks? Technology stocks, in particular, are notoriously risky. That’s why we don’t actually invest in most of the stocks we cover. Instead, we’ve developed a dividend growth investing strategy – Quantigence – that helps us objectively create portfolios of companies that provide income streams that grow every year.
You will not find “the next Microsoft” but you may find some technology companies to invest in that outpace the growth of the broader stock market because they’re doing something disruptive. Larger companies tend to be lower risk when it comes to the likelihood they’ll pull a Bind Therapeutics and go bust.
While we’re holding 30-40 tech stocks at any given moment, the lion’s share of our investment dollars are in dividend growth stocks because we’re strongly risk-averse. Once you get your fingers burned a few times, you’ll realize just how risky tech stocks actually are. We want to do everything we can to minimize that risk, and we always make sure our readers understand the risks they’re taking by investing in any given stock.
This is where we’re supposed to cherry-pick some time frame and show everyone how great our portfolio performed against a benchmark we also cherry-picked. That’s not how we roll. We went back and put together all the pieces to publish a piece on Calculating Our Nanalyze Tech Stock Portfolio Performance. Remember, you can always torture the data until it tells the audience what you want it to.
They say you shouldn’t toot your own horn and always be humble. Those people have never been to business school, where you’ll quickly learn to blow your own whistle as loudly and as often as possible if you expect to climb the ladder in the corporate world. Many analysts out there who cover tech stocks have ulterior motives that go beyond trying to educate the masses. Many articles you’ll see from mainstream investing sites will simply be clickbait lead magnets that try to get you to invest in a particular stock. Anyone who tells you to only invest in one stock instead of telling you about the importance of diversification does not have your best interests in mind.
We became tired of not being able to find objective, transparent, and quality research on tech companies, so we started producing it ourselves in the form of Nanalyze premium articles. We’re continuously learning and improving our research methods as we go along. We’ll continue to engage with our premium subscribers to find out more ways we can add value for retail investors of all experience levels.