Investors Should Pump the Brakes and Do This Before Buying or Selling Beaten-Down Growth Stocks

Remember high school English class? Well, it could come in handy for your portfolio.

One of the first things you learn about writing is the importance of a good thesis. It’s the foundation of the argument you’re trying to convey. Without it, your essay lacks direction.

The same concept applies to investing. Before buying a stock, you need a well-researched thesis for why you think the company will perform well. That 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 off the stock, it might 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 on risky growth stocks, investors need to revisit their theses before adding to (or selling) their big losers.

Image source: Getty Images.

A real-world example

Let’s look at severely struggling growth stock Upstart Holdings (NASDAQ: UPST) as an example. The thesis for the stock might look something like this:

Upstart is likely to outperform over the long-term because it’s disrupting the lending industry with its artificial intelligence (AI)-based underwriting system, which it believes is far superior to the widely used FICO-based underwriting. Since 2018, the company has demonstrated lower default rates on loans it originated 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 going public in late 2020, the stock has seen its price soar 780%, but it has given all those gains back and more. It’s currently down 40% from its IPO price and 93% off its all-time high. Based on the thesis above, what should investors do? To answer that, we need to look at the reasons for the decline.

Why Upstart is down big

Outside of the broader market sell-off, there are two main reasons for Upstart’s struggles.

First, the company is having trouble selling its loans. Upstart’s business model is to use its AI-based underwriting platform to originate loans and then sell them to institutional investors and banks as asset-backed securities. This worked out great until the Fed began raising interest rates. Higher rates mean higher defaults, and now investors are less motivated to buy loans from an unproven underwriting system.

The second reason for the decline stems from the first. Because Upstart is now having trouble selling its loans, it elected to take on the risk of several hundred million dollars in loans in its own balance sheet. Investors did not like this announcement and immediately sold off the stock. To rectify the situation, the management team decided to sell the loans at a loss to restore its balance sheet.

While I largely look at this as a wise long-term decision, it will severely hurt the company’s revenue in the short term. All this has led management to announce lower forward guidance twice in the last two quarters.

The thesis adds clarity

It’s safe to say it’s not a pretty picture for Upstart at the moment. But what should investors who bought the stock with the above thesis do now?

With the gloomy outlook, it’s tempting to just exit the stock altogether. And while that could be the right choice based on your risk tolerance, most investors would like to avoid realizing a loss of that size. The decision becomes clearer when you revisit your thesis. Just ask yourself: “Is my thesis wrong?”

Despite the headwinds, the thesis has not yet been proven wrong for Upstart, since its loans have been outperforming FICO loans so far. But it also hasn’t been proven right either. Upstart will need to demonstrate that its origination system works in boom and bust cycles alike, so it can sustain investor demand.

And as we enter a less stable credit cycle, investors should watch the company’s statements and reports for indications of outperformance or underperformance compared to FICO-based loans. This will tell you what to do with the stock moving forward.

By revisiting our original thesis, we’ve systematically arrived at the conclusion to watch and wait instead of selling or adding to our position. As a long-term investor, you’ll find this is more often the conclusion you’ll arrive at.

Your thesis is like the GPS for your investing journey

Imagine taking a road trip without GPS or a map. It would be nearly impossible to arrive at your destination. Well, that’s what investing without a thesis is like. You will almost certainly make poor decisions about your stocks if you don’t document and revisit your reasons for buying them in the first place.

Before deciding to buy or sell the worst performers in your portfolio, make sure you’re conducting a similar exercise to the one above.

10 stocks we like better than Walmart
When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

See the 10 stocks

Stock Advisor returns as of 2/14/21

Mark Blank has positions in Upstart Holdings, Inc. The Motley Fool has positions in and recommends Upstart Holdings, Inc. The Motley Fool has a disclosure policy.

Leave a Reply

Your email address will not be published.