I will interrupt my near-constant stream of analysis of this month's wild markets for a reality check. By following the DJIA, S&P 500, Russell 2000 and Nasdaq 100, it is possible to miss part of the bigger picture. Publicly traded equities require years of experience to analyze -- and after 26 of them, I have certainly not figured out how to accurately predict their movements. I probably never will.
That's part of the lure of startups. With funding generally done in rounds (Series A, Series B, etc.), the valuation of those companies is not subject to the volatility of stocks. That value can be ridiculously high, just as it can for equities, as shown in published reports indicating Uber was valued at $120 billion in in its most recent funding round.
So, how do individual investors participate in startups? The worst way, in my opinion, is to wait until a startup becomes fully-fledged and the company does an IPO. As an individual, you will never get an allocation of a hot deal stock, so you'll have to buy on the first day. This late in the business cycle is a recipe for disaster, as the good deals have been done. You will hope for Action Alerts Plus holding Amazon (AMZN) or Netflix (NFLX) -- and more likely end up with a complete dog like Snap, Inc (SNAP) . SNAP traded as high as $26 per share on its IPO date of March 2, 2017. After reporting yet another quarter of user losses Thursday and plummeting in after-hours trading, though, I believe SNAP will threaten $6 per share in Friday's trading. That is a big loss, and one you cannot afford to take.
Another way is to buy an established company that is incubating startups in-house. Autonomous vehicles are a good example. Alphabet's (GOOGL) Waymo and General Motors' (GM) Cruise are two of the leading players and are able to subsidize the inevitable losses of a startup from the profits of an established business. The issue here is materiality. If the core business shows any signs of slowing, as seen in Action Alerts Plus holding Alphabet's Google search business in its third-quarter results, reported Thursday night, the stock will fall regardless of the potential of the in-house startups.
Similarly, GM is under pressure to report strong earnings on Oct. 31, after Ford's solid results Wednesday. And if GM does not impress The Street next week, that stock will hit the $20s again. That type of valuation would completely ignore the $14.6 billion valuation placed in Cruise by the recent investment from Honda Motor, but that is the issue of scale and materiality in full focus.
The third option, and my preferred route, is to find attractive micro-cap stocks. I attend more investment conferences than any sane man should, and the issue with these companies is that the vast majority of them are constantly in capital-raising mode. There are some very, very, interesting stories, however, and sifting through the coal will eventually produce a diamond or two. Issues of dilution aside, the need to raise fresh capital makes the management team at the average micro-cap company quite approachable -- and indicates that the information a potential investor is getting is always fresh. That is not the case in large-cap companies, owing to their hierarchical structure.
It probably goes without saying, but I will say it anyway: Micro-cap and nano-cap companies by their nature are very risky -- and the stocks should be approached in that manner. If an investor takes the appropriate level of caution, though, asymmetric returns can and will be produced. I will have a list of the most intriguing micro-cap companies I am buying these days in my column tomorrow.
