12/1/22
Stock down 75%? Keep it simple silly!
The adage "buy low, sell high" is one that every investor is acquainted with - a fundamental principle of investment. However, investors are also all too familiar with the apprehension that arises when buying into a market that seems to be in free fall.
This unease often leads to complacency, which can ultimately result in significant opportunity loss. In this article, we’ll cover why we at RollingWave Capital like to take a step back and look at the bigger picture and how we can help you navigate this.
What You Should Consider When Looking for the Best Risk/Reward
It is important to remember that the most significant future profits are made when the market drops by 20% or more, rather than when it rises by the same percentage in a frenzied market.
Despite this fact, investors tend to become overly cautious and analytical after major market declines. We contend that when a position has plummeted by 75% from its all-time highs, the analysis required to determine whether it is a worthwhile investment becomes quite straightforward.
Finding the Right Stocks to Buy
Finding stocks that have fallen 75% from their all-time highs can be a challenging task in most market environments. However, after the events of 2022, such stocks were more abundant than usual. In this article, we aim to present a different perspective on identifying potential investments and why we consider them to be an excellent way to achieve alpha in a challenging market.
How RollingWave Capital Approaches Stock Portfolio Construction
At RollingWave Capital, we use a combination of technical and fundamental analysis to construct portfolios for our clients. Our approach involves utilizing fundamental analysis to decide what to buy and sell, while technical analysis helps us determine when to buy and sell.
When considering a stock, the first factor to evaluate is whether the company could go out of business. While any business can potentially fail, we focus on the likelihood of it happening in the next 1-3 years, as we don't build portfolios with stocks that we believe will perform well over the next two decades. Instead, we concentrate on a shorter time horizon to build successful portfolios that have a chance of outperforming the broader market.
The Binary Review Helps RollingWave Capital Keep it Simple
Therefore, the "binary review" is a crucial part of our analysis. Binary is the simplest computer code, made up of 0's and 1's. Thus, when examining a position, the first question to ask is whether the position could go to 0 or not.
We argue that if a position cannot go to 0 and is down 75% or more, it should be purchased. That’s it. Not the industry. Not the P/E ratio. Not the short ratio. Not even earnings. This belief is due to positions that have fallen 75%, and are not ultimately heading to 0, do not languish at those depressed levels for long. As in, a position that has dropped 75% either keeps going to 0 or rebounds relatively quickly. RollingWave Capital understands that no strategy is guaranteed, so we often add these positions as “satellite positions.” Small positions surrounding larger core positions. RollingWave Capital believes that this is an excellent way for investors who hold stocks to outperform the broader market.
How Does RollingWave Capital Analyze if You Should Buy Low Sell High
New concepts are best explained using extreme examples. Although nothing in investing is certain, except for the apocalypse, it's widely agreed that the S&P 500 (SPY) cannot go to 0 in the next three years. We challenge anyone to present a convincing thesis on how Microsoft (MSFT) or Apple (APPL) could go to zero within the same timeframe. Could Nvidia (NVDA), Netflix (NFLX), or the world's largest social media company (META) go out of business in the next three years?
The S&P 500, Microsoft, and Apple were never down 75% during the most recent sell-off. However, the NASDAQ was…. between 2000-2002, as were Microsoft, Apple, and Amazon. While it would have taken a crystal ball to predict that these companies would not go out of business in 2002, the point is they didn't, and they ended up becoming market leaders. Fortunately, we can learn from the past. The dot-com crash occurred due to a new industry emerging, and investor enthusiasm becoming irrational, similar to the crypto market's experiences over the past few years. Conversely, the recent market sell-off was due to rising interest rates to combat inflation and the fear that higher rates and inflation would cause a recession. Typically, people may lose jobs during a recession, but mega-cap companies don't fold up shop.
Why is Buying Low (-75%) So Difficult?
Most stocks that trade down 75% from all time highs typically do so in an environment that produces much fear and anxiety. Does a mega-cap stock being down 75% indicate the bottom? Not necessarily, but the downside risk is limited relative to the potential upside. When Bitcoin (BTC) was at its lows in November, it was down 77% from its highs, and yet many believed it had another 50% to fall. However, it has since rallied over 50%. In our view, Bitcoin has reached critical mass, and there are too many interested parties to let it disappear.
Similarly, Nvidia, Netflix, and Meta were all down over 75% at their lows and have since outperformed the market significantly. There were plenty of other examples. Hence, you may argue that this article is two months too late. That’s fair, but we will undoubtedly see another large market pullback in the coming years that will devastate plenty of stocks.
In Conclusion
The point of this article wasn’t to screen for the stocks that meet the criteria, but rather to get you to look at stocks slightly differently. So when the next big pullback happens, you’ll be ready.
JC