My Strategy Lab colleague Norm Rothery, who achieved an impressive 33-per-cent one-year return with his model value portfolio, wrote a column last week with some important advice. Don’t just copy his portfolio, he insisted.
Let me echo his words. My model growth portfolio currently consists of only nine stocks, all of which are technology related, and all of which can be hugely volatile. Consider my model positions to be a small sliver of a well-diversified portfolio.
To illustrate the risks in my strategy, look at my July investment in DragonWave Inc., a small-cap Canadian vendor of wireless equipment for 4G cellular networks. At the time, DragonWave was looking at strong prospects in Asia. I also figured the company might get a potential boost from Sprint’s takeover by Japan’s Softbank Corp., a move that had the potential to result in $16-billion (U.S.) of capital spending over the next two years.
DragonWave is in a great position to benefit from this possible spending surge. But in the three months I’ve held the stock, it has declined 40 per cent.
I was recently asked if I’m sticking with DragonWave. The answer is an unequivocal yes. Volatility is the only guarantee when you hold stocks like this.
I try to ignore stock prices and focus on business results instead. So how is DragonWave doing? Last quarter, it appears to have reversed a revenue decline and confirmed the strength of its sales pipeline, but it is still burning substantial cash, which led to an equity financing.
Allow me to be very blunt. If business deviates too much from what DragonWave management expects, bankruptcy is possible. The company is sitting on about $33-million (Canadian) in cash, and expects to burn $10-million to $12-million this quarter alone. Things have to go right for the rest of 2013 and early 2014, or the stock has plenty of downside left.
That said, at recent prices around $1.80 per share, I think the business is in better shape than it was one quarter ago. The company has added cash to the balance sheet while stepping one quarter closer to the realization of significant revenue growth. I’m actually more comfortable holding the stock today than I was three months ago.
Keep in mind this is a company with highly regarded products. Spending on 4G networks is accelerating, and DragonWave builds what I believe to be the best equipment in the world to wirelessly connect cell sites to an operator’s network. It’s busy with customer trials, deployments and vendor beauty contests.
At its recent share price, and with about 61 million shares outstanding if options and warrants are included, the company’s market cap is $110-million.
If it pulls through its tough transition period and doubles its quarterly revenue by closing a few deals, I think the stock will at least double from here. If the company can get back to being sustainably profitable in the next year or two, we’re looking at even larger gains.
When I added this stock to my model portfolio, I was well aware of the risks. So I made a relatively small bet (3 per cent of my portfolio) on a potential multibagger that could also go to zero within one year.
I don’t make many investments where the potential outcomes are so drastically different, but I’m familiar with DragonWave’s business, and feel it’s worth the risk. But I don’t think anyone should blindly copy what I’m doing. You have to make your own decisions based on businesses that you follow closely. And you have to stomach the losses when they eventually happen.
So far, out of the 10 stocks I’ve purchased, seven are winning. I believe the three losers – Apple Inc., Rackspace Inc. and DragonWave – all have a solid opportunity to trade much higher in the coming years.
I will never panic and sell a stock just because it’s heavily underwater. Trading on emotion is a mistake. Instead of worrying about day to day stock prices, I find it smarter and less stressful to focus on long-term business performance.
Even for very volatile stocks, you have to think like a business owner, not a casino visitor. If there’s one aspect of my strategy you should emulate, that’s it.