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DIVE DEEPER: IS THE WORST OVER FOR BEATEN-DOWN TECH STOCKS?

This week, we had the pleasure of reading commentary by Ethan Wu over at the FT, and we wanted to share our takeaways with respect to a few of the biggest names in fintech.

As a case study on iconic yet speculative tech stocks from 2021, let’s consider Robinhood and Coinbase.

Both stocks IPO’d last year, rode the surge in retail trading related to meme stocks and crypto, and have recently touched 85% declines from their peaks amidst probes by government regulators.

This past month or so has been much more favorable to these stocks, and the recoveries, at least for Coinbase who announced a partnership with BlackRock recently, have partly been backed up by positive news.

See their returns for the year below:

Growth(?)

Markets have generally seen a return in risk-on sentiment lately, and the question is whether we’ve seen enough pain yet for a bottom to be in with these sorts of growth stocks.

We say growth with a question mark, because well, their future growth is anything but certain.

Coinbase appears to be embarking on a defining struggle for the digital asset industry, as the SEC questions whether many of the cryptocurrencies listed on its platform are unregistered (illegal) securities. If it loses, its entire existence comes into question.

Robinhood’s business model is also in question, not just because of past disputes with the SEC, FINRA, and the state of New York, but also just because they remain deeply unprofitable at a time when this is going out of style for tech stocks amongst investors as interest rates rise.

Can Robinhood continue then to be a loss leader in such an environment?

Or will they fail before they hit enough scale to leverage services that might make them real money, rather than offering commission-free trading and negligent amounts of leverage to Reddit traders?

Despite these dynamics, the two stocks have bounced faster recently than the rest of the market with Coinbase up over 70% in the last month, and Robinhood up 27% over the same period.

On metrics like price to sales, which is commonly used for unprofitable Silicon Valley companies, their valuations have come down tremendously.

But does that actually make them cheap? Probably not.

Wu highlights that these companies, and many of their peers who issued stock excessively to entice top talent in 2021, may be in serious risk of an equity dilution death spiral.

What does this mean?

Well, the basic idea is that blossoming tech companies have for years notoriously used stock-based compensation as a means to bypass their limited liquidity at the expense of shareholders.

Shares are awarded through four-year vesting plans known as restricted stocks units (RSUs). When the shares are received, individuals are subject to income taxes, and then later face capital gains taxes should they sell.

Estimates from JPMorgan suggest that Coinbase has paid out 35% of its total compensation using RSUs, and Robinhood has used it for as much as 50%.

The problem here is that not only does this reliance on equity issuance significantly dilute all other shareholders, but as the value of these stocks collapse, so does the value of the employee compensation.

As top employees realize that their shares may be worth far less than initially expected, they’re likely to demand more compensation or simply exodus from the firm.

For unprofitable tech companies, increasingly tight on liquidity as interest rates rise, they face the choice of either paying out more shares and causing greater dilution, or coughing up much-needed cash intended for continued operations and growth projects.

Takeaway

It’s unclear how real this death spiral is, though we can certainly imagine how such a scenario may be unfolding currently at companies like Coinbase and Robinhood right now, as they balance the costs of retaining top talent with greater compensation or layoffs.

Should their best and brightest go elsewhere to more established companies that can afford to pay them well, we’d also expect RSU-dependent firms to deteriorate and underperform with time.

What do you think – is a share-based compensation feedback loop really a threat to these stocks?

(Hit reply to let us know)

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QUOTE OF THE DAY

“Emotional intelligence is more important than book intelligence.”

—Morgan Housel

What?! Did anyone tell you something like this when you headed off for college?

Investing, and certainly life in general, may have been smoother had some sage or wise uncle pulled you aside and let you know this.

While we would never discount the importance of continuous and never-ending reading, book intelligence alone won’t bring you the investment results the world’s top investors enjoy.

What to know

Many of you may have heard of Morgan Housel, a former columnist at The Motley Fool and Wall Street Journal and the author of the international best-selling book, “The Psychology of Money.” If you haven’t had a chance to read his book, we would encourage you to order it now.

Morgan is also a partner at Venture Capital and PE firm The Collaborative Fund. He’s been a friend of TIP, and Trey Lockerbie did a fantastic interview with him on We Study Billionaires #351 that is well worth the listen.

So how do we increase our emotional intelligence?

For that, we will turn to none other than our own William Green, who interviewed Daniel Goleman, author of the best-selling book, Emotional Intelligence, on Richer, Wiser, Happier.

Emotional intelligence includes self-awareness, self-management skills, empathy, and social skills.

Can you stay calm in a chaotic situation? How do you maintain focus?

Think of an investor, and one of his largest holdings is plummeting in price. He’s overwhelmed by fear and anxiety. How do you handle that?

A primary key to emotional intelligence is self-awareness, which leads to being able to manage yourself well. It allows you to know what you’re feeling, why you’re feeling it, how it’s impacting you, how it’s driving your thoughts, and how it’s driving your impulse to act.

Emotional maturity is widening the gap between stimulus and response or between an impulse and action. If you’re going to be a good investor, according to Goleman, you don’t do what your emotions tell you.

Basic meditation and breathing techniques can help with this. There’s a good reason many investors such as Ray Dalio meditate daily, which we all may want to consider.

There is a mnemonic we also may want to learn, which is HALTPS. It stands for hungry, angry, lonely, tired, in pain, or stressed.

Closing thoughts

When you recognize you are experiencing any of the above, it is a precondition for making a terrible decision.

So don’t do anything hastily when you are experiencing any symptoms of HALTPS and widen the gap between stimulus and response.

Developing emotional intelligence is a challenge, but it’s what the world’s best investors and leaders continue to develop.

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