When I wrote that volatility would be increasing (Bidding Farewell to January), my gut was telling me that we were in for a tough stretch. Sometimes it pays off to listen to your gut…the last two months of the quarter were less than enjoyable.
Check out the below chart on the VIX (volatility index). Increases in volatility aren’t necessarily correlated with down markets, but they frequently go together. Regardless, increases in volatility typically lead to investors getting more cautious, which is definitely not a good thing for riskier stocks, for which microcaps are the poster child.
Overall, Q1 was positive for Tailwinds as we finished the quarter up 7% on the year, which beats the indexes (Russell 2000 was flat). However, at our peak, we had about a 20% differential which got obliterated in the last two weeks. This happens. As I tell everyone, Tailwinds aims to outperform over time, but, in a down market, we will likely take it on the chin.
My stated opinion, which remains unchanged, is that we are not in a down market. There are major crosscurrents at work here, but fundamentals are very strong. So, despite our presidents best efforts to scare the world (and investors), tax breaks and a strong economy create opportunities for growth. And, growth is the key for microcaps to outperform.
However, the possibility of the next big move in the market being down is probably much greater than a big up move. This is primarily because the leadership of the market is rapidly disappearing.
There has been a lot of talk over the last few years about how the strength in the indexes is deceptive; most of the gains have been achieved in a handful of stocks. Commonly referred to as the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google), these stocks have accounted for a significant percentage of the market’s strength. This trend is changing.
As the above charts show, YTD three of the FAANG stocks are down and Amazon and Netflix are both showing signs of weakness lately. These companies are all great companies. However, their valuations have gotten way ahead of the fundamentals. Eventually this catches up with a stock. In the case of the FAANGs, their valuations being too high will have collateral damage to the whole market.
If the FAANGs weaken more, the market will likely correct overall. Even if this doesn’t happen, it’s tough to see the leading a charge to new highs, what with the Trump government putting a few of these stocks in their sights. So, with a lack of leadership, this market becomes a stock picking and trading game, not a one-way ticket higher.
It certainly is a minefield out there right now, so investors need to stay on their toes. Due diligence is more important now than ever; the rising tide lifting all ships has stopped coming in. However, check out the performance of the individual Tailwinds recommendations for the 1st quarter; as you can see, it’s tough, but not all stocks are down. Opportunity still exists in a big way.
Going forward, I think Tailwinds is well positioned to outperform the market. Some of our names have been hit hard, which, if I’m correct on fundamentals, creates a buying opportunity. The key is to avoid being wrong on fundamentals. Avoiding blowups when you invest in “public venture capital”, which these really are, is the way to win in microcaps.
Meanwhile, Q2 is littered with catalysts for the portfolio. I’m expecting it to be interesting and, hopefully, profitable. It will certainly remain volatile. And, as I suggested in last week’s newsletter, it will likely not be one-directional. The key to Q2 (and possibly the rest of 2018) will not only be picking the right stocks, but trading around these positions.
It will also be important to pull the trigger when it’s time to move on from a stock. In Q1 we removed three names from the portfolio. These moves were done rather abruptly, as some observed, but portfolio management is not a static activity; when it’s time to sell, in a volatile market, it can often be a race for the exit. Since we sold, MARK is down well over 50%, Vuzix is down around 33%, and T2 Biosystems is down over 10%.
Two weeks ago, I went to 40% cash in my own account. Thursday of this week, I finished redeploying capital, back to fully invested. The Tailwinds Select Portfolio remains fully invested, but, going forward, for premium subscribers, I will be offering additional insights into trading around these positions to maximize returns in a volatile market. If you’re interested in becoming a premium subscriber, please let me know.
Let’s discuss a couple of these names:
At the beginning of the new year, I said CATS was a great pick for 2018. This is as true now as ever. The company has some exciting catalysts in front of it, a growing business with a large moat, and the ability to obtain funding if needed.
In the current environment, ability to obtain financing (or, better yet, not need more funding), is a huge determinant for stock performance.
A great example of this is ITUS. ITUS was our top performer in Q1, but it should have done better. The data coming from their trials, data confirmed by Memorial Sloan Kettering no less, is outstanding. They are likely going to change the way cancer is diagnosed. Yet, an ill-timed attempt to raise additional (not really needed) capital, hammered the shares last week.
As a pre-revenue healthcare company, ITUS will need more money eventually. However, their model is one of outsourcing to partners and they are funded through the balance of 2018. Part of their strategy is upfront payments from any partners, which would just lengthen their runway. Based on the data presented by ITUS, with a strong likelihood of them announcing a partnership in Q2, funding is really not a needed item. I expect them to cancel their latest financing plans after which this stock should continue to perform.
Resonant (RESN) is another name that exemplifies the risk to your share price associated with financing. In their case, they did a deal two weeks ago and, in the process, shot their share price in the foot. This has been a painful stock as the price has gone down and, in my opinion, they have mismanaged their capital markets’ strategy; they didn’t need to do a deal.
Investors are very frustrated with RESN. I get emails and calls about them frequently, with many people throwing in the towel. Is this the right thing to do? I don’t believe so. It’s emotional to sell a stock that’s down. Look at the fundamentals. Business is performing (maybe a little slow, but still ramping nicely). Meanwhile, with the recent financing, RESN is fully funded. Taking a non-emotional view, the stock is better positioned than ever. The market cap is well below the total dollars invested in the business to date and it’s got about $40M in cash!
This is a screaming buy. Unless you already own it, in which case it’s painful and tough to step deeper into the maelstrom. I am feeling the pain, too, but have continued to buy. Time will tell if I’m correct, but, when I separate my emotions from the decision, buying more is the right trade.
Remaining on the theme of financing dictating share price, ENDRA (NDRA) was our second worst performer. Not a large position, and an incredibly cheap stock based on risk/reward, it’s obvious that NDRA requires additional capital sometime in Q3. A date that is rapidly approaching.
The good news for ENDRA is they will have data out in Q2; data that validates their technology. I see little risk with this. However, it will need to be followed by a financing. I’m sticking with the company as I believe that, once the financing risk is off the table, the stock will be dramatically higher. There is limited liquidity and, unless you participate in the financing, you’ll likely not be able to buy the stock once the deal is done. So, I sit with my position and know that it will continue to weigh on me.
On the safer side, let’s talk about companies that don’t need money, or have access to it. These are stocks that should be able to move on news and fundamentals, without reversing on financing risk. Realize, of course, that THERE IS ALWAYS ANOTHER FINANCING COMING!
I’ve put them in a few buckets. If you are investing in some of our stocks, it makes sense to consider where they stand on a financing basis as the first thought when performing due diligence.
We generate cash and don’t need money! FTNW and MOMT. Lucky ducks, these stocks are not at risk of a down round.
We likely have enough cash to make it to cash flow positive. SGBX, RESN, CYRX, IWSY and ATOM. These guys are all at inflection points where they should be at cash flow positive soon as their businesses launch. They will likely come to market at some point, regardless, but it will be at their discretion, not the market’s.
We recently did a deal and are not coming to market anytime soon. These stocks all have cash on the balance sheet and have a chance to start generating some decent cash flow prior to another round of financing, so are at much less risk from a capital perspective. RESN fits in here as well, joined by PTOTF and CDXC
We have deep pockets backing us, so fear not. The ability to get more funding as needed is a wonderful backstop. Both CATS and CDXC fit in here; there truly is limited, if any, risk in terms of financing for these companies.
Despite the volatility and the recent selloff, I remain convinced that 2018 will be a great year for Tailwinds. Our companies are disruptive, have huge potential markets, and are seeing operational success. Those are the essential elements for a company to be in the Tailwinds Select Portfolio.
If companies stop fitting this profile, I’ll remove them from the portfolio. Otherwise, we remain committed to staying the course. It will be volatile, but the ultimate reward for picking successful microcaps is well worth the ride.
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