Investors should pump the brakes and do so before buying or selling battered growth stocks
Do you remember English lessons in high school? Well, it could be useful for your wallet.
One of the first things you learn about writing is the importance of a good thesis. This is the basis of the argument you are trying to convey. Without it, your essay lacks direction.
The same concept applies to investing. Before you buy a stock, you need a well-researched thesis on why you think the company will do well. This investment thesis guides your decision-making. If the argument is busted, it’s time to sell. If it’s intact and the market has sold the stock, it may be time to buy more.
But more often than not, your thesis reminds you to keep calm and do nothing. While it’s tempting to buy the dip in risky growth stocks, investors should reconsider their theses before adding (or selling) their big losers.
A concrete example
Let’s look at the struggling growth stock Assets received (UPST 8.39%) for example. The stock thesis might look like this:
Upstart is likely to outperform over the long term as it disrupts the lending industry with its artificial intelligence (AI)-based underwriting system, which it claims is far superior to widely used FICO-based underwriting. Since 2018, the company has demonstrated lower default rates on the loans it issued compared to FICO loans. If this outperformance is sustainable over the long term, Upstart could capture a significant chunk of the $3 trillion addressable lending market.
Since its IPO in late 2020, the stock has seen its price soar 780%, but it has returned all of those gains and more. It is currently down 40% from its IPO price and 93% from its all-time high. Based on the thesis above, what should investors do? To answer this, we need to look at the reasons for the decline.
Why Upstart is down
Outside of the broader market sell-off, there are two main reasons for Upstart’s struggles.
First, the company is struggling to sell its loans. Upstart’s business model is to use its AI-powered underwriting platform to originate loans and then sell them to institutional investors and banks as asset-backed securities. It worked very well until the Fed started raising interest rates. Higher rates mean higher defaults, and now investors have less incentive to buy loans from an unproven underwriting system.
The second reason for the decline stems from the first. Because Upstart is now struggling to sell its loans, it opted to risk several hundred million dollars worth of loans on its own balance sheet. Investors did not like this announcement and immediately sold the stock. To rectify the situation, the management team decided to sell loans at a loss to clean up its balance sheet.
While I consider this a wise long-term decision, it will seriously hurt the company’s revenue in the short term. All of this has led management to announce lower guidance twice in the past two quarters.
Thesis adds clarity
It’s safe to say that’s not a pretty picture for Upstart right now. But what should investors who bought the stock with the above thesis do now?
With the bleak outlook, it’s tempting to just get out of the stock. And while it might be the right choice depending on your risk tolerance, most investors would like to avoid making a loss of this size. The decision becomes clearer when you revisit your thesis. Just ask yourself, “Is my thesis wrong?”
Despite the headwinds, the thesis has yet to prove wrong for Upstart, as its lending has so far outperformed FICO lending. But that has not been proven either. Upstart will need to demonstrate that its origination system works in both boom and bust cycles, in order to be able to sustain investor demand.
And as we enter a less stable credit cycle, investors should monitor company statements and reports for indications of outperformance or underperformance relative to FICO-based lending. This will tell you what to do with the stock in the future.
By revisiting our original thesis, we have consistently come to the conclusion to watch and wait instead of selling or adding to our position. As a long-term investor, you will find that this is more often the conclusion you come to.
Your thesis is like the GPS of your investment journey
Imagine going on a road trip without GPS or a map. It would be nearly impossible to get to the destination. Well, that’s how investing without a thesis is. You will almost certainly make bad decisions about your stocks if you don’t document and review your reasons for buying them in the first place.
Before deciding to buy or sell the worst performers in your portfolio, be sure to perform an exercise similar to the one above.
Mark in white has positions in Upstart Holdings, Inc. The Motley Fool has positions and recommends Upstart Holdings, Inc. The Motley Fool has a disclosure policy.