How to Handle the Red in Your Portfolio

Talking you through market volatility.

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This video was recorded on Dec. 3, 2021.

Dylan Lewis: It's Friday, December 3rd, and we're talking about how to handle seeing some red in your portfolio. I'm your host, Dylan Lewis, and I'm joined by Fool.com's best boy of big bursting bubbles, Brian Feroldi. Brian, how's it going, man?

Brian Feroldi: Dylan, it's going OK as usual, I got my yoga session in before we're taping this morning, so I feel good. Feel a little less good when I opened up my brokerage account though.

Dylan Lewis: So the blood pressure came down and then went immediately right back up, right, Brian?

Brian Feroldi: That's how it's working today, unfortunately.

Dylan Lewis: I'm sure there are a lot of folks feeling the same way. I'm feeling the same way. I was watching some after-hours news come in, related to some earnings. I saw a company that has been a big winner for me for a long time. DocuSign get hit hard down 40 percent today and not alone. There are a lot of very high-growth companies that people have gotten used to putting up some pretty stellar results during the pandemic and during this big digital push that we've seen. A lot of them have come back down to earth recently, Brian. We're going to talk about that. We're talking about the general dynamics of the tech sector and the way that a lot of these indices haven't been hit nearly as hard and really how people should be thinking about all of this stuff as they check their portfolio on a day like today.

Brian Feroldi: I know that every time I've checked my portfolio over the last couple of months, I haven't been all that excited with what I've seen. A lot of my personal net worth is in high-growth dynamic companies that are in the small or mid-cap sector. Really, a lot of my investments have been really hammered in recent months. However, if you look at just the big indices, you don't see nearly that same level of volatility. In fact, the S&P 500 and Nasdaq, those are only down about three percent or five percent from their recent highs, which are basically like non-events.

Dylan Lewis: Yes, it's funny. For me, it's like which accounts did I check? Did I check the Vanguard accounts, where I've got mutual funds? If so, things look fine. Did I check my individual brokerage account where I'm owning individual stocks? That's where the pain has lived and I'm sure that a lot of people are seeing and feeling very similar things. Year-to-date results for both those indices have been strong up over 20 percent. But if you're owning individual stocks, especially some Fool favorites, you've been feeling the pinch recently.

Brian Feroldi: Yes. How about this for some recent pain? This is going to be the percent down, that these companies are from their recent high or the 2021 highs. PayPal down 39 percent, Palantir down 50 percent, Bumble down 60 percent, Teladoc down 72 percent, Chegg down 74 percent, and Zillow down 72 percent.

Dylan Lewis: That's tough. Those are some big numbers to see. We have to remind ourselves, those are down from highs. These are a lot of businesses that have seen some very high highs recently. So some of this is a little bit relative. But, Brian, what's incredible to look at that basket of stocks is where you too have bought that as a basket and said, "I'm going to buy this and leave it alone for 5, 10 years." I'd say these are a lot of businesses that have some pretty awesome tailwinds behind them.

Brian Feroldi: If you could get into the recent results of a lot of these companies, most of them are doing exactly what they set out to do. They're growing their revenue, they're increasing their margins, perhaps not as fast as they were 30 days ago or 60 days ago. That's understandable given the dynamics of COVID and stay-at-home orders versus the world opening up. But that is just a taste of some of the downturns that we've seen in individual stocks. There have been dozens of examples of high-growth companies that have gone through this type of pain.

Dylan Lewis: Some of those businesses are in these industries that we said before, S&P 500 or the Nasdaq 100. Those indices, Brian, have not felt the pain in the same way. A big part of the reason why is because while high-growth has sold off, Big Tech has not really sold off in the same way.

Brian Feroldi: Really, mega-cap tech has not sold off in the same way. So if you look at the big Fang stocks, many of them are down, about the same amount as the index as a whole. So just a few percent. I mean, some of the bigger declines in Big Tech as Amazon are down eight percent or even Meta, the artist formerly known as Facebook, I guess we should say, down 18 percent. But if you look at the big tech stocks, many of them have not declined nearly as much as their smaller mid-cap counterparts.

Dylan Lewis: I think that there's a really good lesson there in allocation and the way that that affects your returns. The two dynamics between the two of them, Brian, because, it is easy in the grand scheme of the S&P 500, five hundred of the world's largest companies. To forget that, it's pretty concentrated. Those five companies worked out to about 22 percent of the portfolio. If those businesses are doing OK, the portfolio is generally going to be doing OK as well. To put some context to the way that return dynamics work here, Apple and Microsoft alone are 12 percent. They each have ten times the allocation of the 21st largest company in the index, which is a little company called Walt Disney. Put another way, Brian, those six companies comprise as much of the portfolio as the bottom 350 companies. So where those companies go, the indices are going to go.

Brian Feroldi: Yeah, and that's just in the S&P 500. If you look at the Nasdaq 100, the concentration is even higher. So there is that factor that's at play. But more importantly, some of the sectors of the markets that were beaten to a pulp and really left for dead in 2020 have shown signs of strength in 2021. Those companies bouncing back and they haven't been hit nearly as hard as some of the growth stocks that we've talked about before, that factor is also helping to bolster their turns of the major industries.

Dylan Lewis: I think it's important to remember all of this because if you're thinking about your own portfolio and your own brokerage account, it's good to get an idea of what you own, but also where your returns are going to come from, your overall portfolio returns. If you have 20 percent of your money in a single stock and the much smaller allocation and a lot of the other things you own, you are going to basically ride with the success or failure of that company. The same is true for these indices. So, it's a nice opportunity to take a step back and apply that same logic to what we see on ourselves, Brian.

Brian Feroldi: That's right. Concentration is the fastest way to build wealth. Unfortunately, the flip side of that is concentration is the fastest way to destroy wealth.

Dylan Lewis: Thankfully, in the case of these big tech companies, they are widely owned by a lot of people. It's the first honor-ramp for a lot of people to get started investing. So if you're a newer investor, hopefully the 401K, the IRA has some mutual funds in there that are basically marrying the S&P 500 and you're not seeing quite as much red. But if you're owning individual stocks, particular high-growth ones, you are. Let's talk a little bit about why that's happening, Brian.

Brian Feroldi: Yes, if there was a big takeaway, it would just be that valuations are contracting. It's no secret that many of the companies that we ticked off before traded at extremely high valuations earlier this year and even after some of these clients, if you have a hard time calling [inaudible 02:39:36] some of these stocks cheap. So their valuations got way ahead of the business earlier in the year and for a number of reasons, investors as a whole have not been willing to pay those extreme valuations in the last recent weeks. That's resulting in the sell-off that we're seeing.

Dylan Lewis: Yeah. Really, we talked about this at the beginning of the year that this was one of the interesting things we're going to have to keep an eye on. It's probably going to be one of the major stories of the year with tech was we saw these companies have these incredible growth get pulled forward. All this stuff that probably would have taken place over a couple of years moving into a period of maybe six or nine months. What does that do for growth expectations going forward? What does that do for investors' expectations of these businesses? What are they going to be willing to tolerate in terms of growth deceleration? How much of a valuation premium are they going to be willing to pay for that growth? These are hard, hard questions to answer, Brian.

Brian Feroldi: Yeah. Overall, the assumptions that investors baked into their model in 2020 was that this hypergrowth is here to stay when that met the reality of we're still growing, just not nearly as fast as we are in 2020, that expectation reset has been a big reason why we've seen so many valuation resets.

Dylan Lewis: You take all of that and then you add onto it the recent uncertainty we've seen with Omicron variant. We have macro uncertainty, inflation, monetary policy. Then we know, Brian, whenever we get to the end of the year, we start to see some whacky stuff. Some of that is people are in the market for a variety of different reasons, a variety of different time horizons. A lot of folks who are handling very large institutional amounts of money are going to do things at the end of the year that are a little different than what you and I might do at the end of the year.

Brian Feroldi: Yeah, for sure. Can you imagine being an investor that has a huge position in DocuSign at the end of the year, you have to report that, where investors could be saying to you, "You own DocuSign? Didn't that company just plunge 40 percent in a year and down 66 percent of its high?" There is some window dressing that happens toward the end of the year with big funds where they sell their worst performers and they add best performers to make it seem like their portfolios were better positioned than they were?

Dylan Lewis: Yeah. Then there's also a bunch of tax stuff that happens at the end of the year, too. I mean, this is something that we're used to in a standard year with people looking to either lock in gains and make sure that as their heading into when they're going to start reporting their full-year results, if they've got really great performance, maybe they want to make sure that they don't lose that in the last couple of weeks of the year. But also if there are opportunities for them to sell some losers and realize some tax loss harvesting, they might try to do that. Then on top of that, Brian, there's uncertainty of what might be happening with the tax code. You have a lot of folks who are saying 2022 might look a little bit different for capital gains than 2021. I think I want to lock myself into the capital gain structure I know exists right now. That also might be playing a role a little bit and why we're seeing some selling.

Brian Feroldi: Sure. Those kind of factors always lead to short-term gyrations in the market and many of them are unpredictable. The other thing that I rarely pay attention to but there's no doubt, as you said before, is just the macro uncertainty related to inflation. I mean, throughout the last decade, since the great recession really, we've seen a tremendous amount of money being injected into the system, and all during that time, inflation was extremely attained. It's only really in 2021 that we've seen any inflation effects at all. So that is a brand-new dynamic that investors are happened to deal with.

Dylan Lewis: Yeah, it has been the specter of 2021, I think, in a way that we forgot about for a while. I don't think we talked about inflation too much over the last couple of years on this show, or really on a lot of Motley Fool programs. It has become something that we're asked about often. We see news headlines about it almost every week. It's just something that we have to pay attention to and maybe in a way that we didn't have to in the past. I think as we're trying to take the broader view here of what's going on, it is important to remember those names that you rattled off earlier, Brian. All but one of them is down year-to-date. You were giving everything off of highs. We talked about the indices being up about 20 percent year-to-date. Almost all of those are down year-to-date. Many of them down 30, 40, 50, 60 percent year-to-date. If you take that step back, though, for the companies that have been around for a couple of years, many of them have positive returns for the past three years, over half of them are market beaters. If you own them as a basket, you'd probably be doing pretty well in part because the outperformance from the multi-baggers have covered any of the underperformance due to those losers.

Brian Feroldi: Yeah. One trick that I always play on myself when I see red in my portfolio is to look at my three-year returns, five-year returns, and my 10-year returns, and I always get a smile on my face when I see those longer-term returns. Obviously, if you just started investing over the last six months or a year, you can't do that, but it is always helpful to zoom out whenever the near-term is going in the wrong direction. If you zoom out and look at the long-term returns of the market, which is what we Fools always try and focus on, you can't help but be thankful that you're invested in the stock market.

Dylan Lewis: Yeah, I think of the tired line. If you don't love me at my worst, you don't deserve me at my best. Brian, I think it's true for relationships. As a Jets fan, I could say it's certainly true for sports teams. [laughs] I think it's also probably true for stocks in your portfolio.

Brian Feroldi: Fair enough, Dylan.

Dylan Lewis: [laughs] If you want that upside, you have to be willing to stomach some of that. It's part of the trade-off, particularly in the hydro space. You're being compensated in a way for the risk and the uncertainty that you're willing to take on. We've talked a little bit about how this sell-off is not being felt evenly. If you're like me, Brian, you have a mix of the big tech stocks, the mutual funds, and these high-growth names that have gotten absolutely hammered. I want to spend a little bit of time talking about two different businesses and present two different cases here because it would be easy to look at something down 50 percent, 60 percent and say, "How can this company come back from this?" I think there is a situation where that decline is totally warranted and a situation where actually this seems like an overreaction and it might be a nice case study for some of our listeners.

Brian Feroldi: Sure. You asked me to dig through there and find a company that seems to be performing just fine and the business level, and immediately what came to mind for me was Palantir, ticker symbol PLTR. This company has had a roller coaster of a ride ever since it came public just a few years ago. If you look at the performance of the business, I don't know how you do not come away impressed. In the most recent quarter, Palantir's revenue grew 36 percent to $392 million. It added 34 net new customers in the third quarter, and its commercial customers, excuse me, grew 46 percent in the most recent quarter, and commercial revenue grew 103 percent in the US. While the company's bottom line is a little bit wonky because of the high stock-based compensation, it reported $119 million in adjusted free cash flow and it's signed more than 50 deals in the quarter that were worth a million dollars, 18 deals of which were worth more than $10 million. If you look at this company's results, you can't help but say thesis for this company is firmly on track. So much so that management reaffirmed that its long-term growth trajectory between now and 2025 is 30 percent annually. Yet this company, as a reminder, is down 50 percent from its recent high in February. What can explain that is valuation. This company traded at 45 times sales in February. Now it trades at just 27 times sales. By the way, that figure still not cheap.

Dylan Lewis: [laughs] That's right. There's still some growth being priced into it. I think that's a nice check, Brian. I mean, there are some concerns as there always have to be with high-growth businesses. I think in the case of Palantir, it's a little bit related to the government segment in particular. We know that the commercial revenue segment selling that will probably drive this business long term. There have been some concerns about what that government segment looks like. Is it slowing down a little bit? But that segment still exists. The commercial revenue segment still looks very strong. There's nothing in that that says, "Wow, 40 percent of this company's revenue just disappeared overnight or 40 percent of this company's future just disappeared overnight." I look at something like that and I'd say, if you're a Palantir shareholder, it's tough. It's really hard to see that, that red in your portfolio. However, nothing in here seems to be moving away from the reason that you bought that stock originally.

Brian Feroldi: The business appears to be doing just fine and as we teed up when we dug through the S1 of this company, we said, if you're going to be an investor in Palantir, it's best to look at this company on a year-over-year basis as opposed to a quarterly basis just because many of the deals they sign are really big in nature, and where they land during the year can really impact one quarter's results versus the other. But as you just said, if you just were given the headline numbers for this company, I don't know how you come away and not say thesis on track.

Dylan Lewis: On the flip side, this company has been talked about a lot, but I think it's helpful in illustrating when things start to go to a concerning space, and that's Zillow. Shares down almost 50 percent over the past six months, 70 percent from all-time highs. This company has gotten a lot of discussion. We don't need to go super deep into it, Brian, but the short of it is this is a business that was so well-positioned to succeed over the last couple of years. Digital business, it was exactly where the world's going. It was not particularly disrupted by COVID. In fact, massive tailwind because of the spike in interest around real estate investing, low interest rates, investors looking for places to put cash, these are all good things for real estate business. However, headlines over the last couple of months, Brian, have been much more focused on the iBuying and buying flipping program, where Zillow appeared to get out over its skis and went from probably having a segment that people were pretty excited about what this business, maybe thought that this was where it was going and it was the future, to having to basically write down that business, let go of a lot of people, and own the fact that it was a mistake.

Brian Feroldi: Yeah, Zillow made a big push into the iBuying business, and I for one was really excited about that shift. I knew that that business had tremendous potential and it was going to be very, very capital-intensive. Zillow with the most traffic in the US in theory was very well-positioned to ride the iBuying wave higher. If you listen to management commentary over the last couple of years, I actually thought they did it the right way. They first did it as an experiment. They saw how that was going, then they slowly rolled it out. Only after they saw some initial success with it did they really decide to ramp it up. Like many other investors, I was surprised when the company pulled the rug out and said, JK, this mega growth business that we have, yeah, the economics are terrible, we're going to be abandoning that. In that case, that was a thesis-changing move by Zillow management team.

Dylan Lewis: Right. If that was a big part of why you own that stock and where you saw that business going, you have to take a haircut on that and admit that that isn't coming together. A lot of money was spent trying to make it happen. Then also I think regardless of whether that was core to your thesis, people might look at something like that and say I want to really trust company leadership. When I see a step like that and then having to walk it back, appreciate them being honest and candid about it, but also it shakes your confidence a little bit in them knowing where the market is going and really being able to lead that industry.

Brian Feroldi: It certainly does. By the way, trying things and failing at them is something that I'm more than OK with. I really like the fact that Zillow has that optionality embedded in it and they're willing to try stuff because if one of those experiments works, it can really be a game-changer for the business. The frustrating thing about Zillow is that they've had this data the whole time, and their data clearly showed them that this was something that was working and then they did an about-face. Now, to be fair, pricing dynamics of the real estate market have been crazy over the last 18 months and their algorithms probably couldn't account for that because of the extreme inflation that home prices have gone through. By the way, one of the companies that I think has the most optionality of any company I've ever owned is Amazon. If you look at Amazon's history, they have plenty of absolute failures. I mean, one that comes to mind immediately is the Fire Phone. Remember that disaster where they were big and excited about it, they thought it was going to take over the iPhone market. Within a matter of weeks, they wrote that thing off as a complete failure. If you're going to try new things, it is natural that you're going to fail sometimes. It's just disappointing that it took Zillow so long to realize that their experiment wasn't working.

Dylan Lewis: Yeah. Brian, I love that point because there are probably some Zillow shareholders out there that have said, "You know what? With this, I'm done. I don't want to deal with this anymore." There are probably a lot of other shareholders that have said, "I'm sticking around for this thing." That's a positive sign if you are aligned with that approach to running a business and taking chances. It's OK if you're not. But understand that those are the types of decisions that these companies are going to make and they may or may not belong in your portfolio because of that.

Brian Feroldi: Yeah. Just know ahead of time that if if you do stick with Zillow, by the way, I still hold my shares. I might be selling out before the end of the year. I haven't quite fully decided yet. But you have to understand that the next essentially year of financial results out of this company are going to be really ugly. Revenue is going to be down. Huge margins are going to be up, but the company is also going to be taking lots of one-time write-downs on losses and stuff like that. It might be a year or more before you see the company's actions today actually result in positive things for the income statement.

Dylan Lewis: Brian, putting it all together, I think the mindset of the Foolish investor, we talked about it so often, but focus on the business and really focus on the thesis. There are a couple of other takeaways, though, that I think are helpful from this conversation. It might just start with taking the long view and really taking a big picture look, both in terms of how you're measuring performance, but also how you are setting your expectations for the companies you own and the industries you invested.

Brian Feroldi: Yeah. I'm a really a big fan of studying market history, especially downturns in market history. If you're just looking at the big indices for many of the reasons that we pointed out before, you might not get a complete picture of what is actually happening in the markets. I vividly remember many, many years ago, I think it was 2012 or 2011 when the markets were leaving growth stocks behind, the markets were rip-roaring higher, and many of the Foolish favorite stocks or growth stocks were just doing nothing, languishing, and underperforming. It feels a lot like those times now. But if you hold the right companies for the time period that they need to be held on and you're right with the selection of the businesses, over time, the best companies will outperform and the worst companies will underperform. If you believe that you have the best companies in your portfolio, you just have to be aware that you're going to go through times exactly like we're going through right now on occasion.

Dylan Lewis: Right. You mentioned portfolio, Brian. I think it's important again, it's best if you can do this when times are good, it's harder if you're doing it when times are bad. But understand your allocation within your portfolio and what that means for where results are going to come from and how subject you're going to be to the swings of any one individual company. As you're looking at those companies, the classic check at shorthand, is the thesis busted? Does this news affect the thesis?

Brian Feroldi: That's a really hard thing to ask yourself when you see the drawdowns that many of these companies have gone through. But this is why I always try and keep my attention focus on the financial performance of the company and not the performance of the stock itself. Another thing that really helps me is to always remind myself the reason that I invested in the first place. I didn't buy stocks and invest because of what they were going to do in the fourth quarter of 2021. I bought those stocks because I want them to help me fund a comfortable retirement in 2040 and beyond. I'm confident at that point in history when I'm looking back right now, I won't even remember this time in history as being a downturn for my portfolio. It can be really, really helpful to always remind yourself what is the reason I made this investment and is my time horizon long enough out that I can take the lumps as they come.

Dylan Lewis: I'm going to set an iPhone reminder for me to shoot you a text in 2040, Brian, being like, "Hey, remember this episode? [laughs] You remember these lumps we took?" I think that's right. I think you have to set yourself up with the long-term mindset and no, this is in some ways the cost of admission for those long-term gains that you're able to enjoy and for that life that you're trying to build for yourself. Hopefully, you're able to go out and enjoy that life and you're not sitting watching the brokerage account move up and down because that's where things can get I think really hard to separate yourself from.

Brian Feroldi: It sure does. One final tip would just be to surround yourself with a community of like-minded investors. That's got to be my favorite thing about the Motley Fool, the people that are involved in this community. Whether you engage with them on the boards, or through podcasts, or through videos, people that take out a Foolish mindset are long-term investors, and you can be darn sure that they're going through the same experiences with you at the exact same time. Going through downturns and investing through downturns is so much easier when you're doing it with a community of like-minded people.

Dylan Lewis: A hundred percent true. I'm lucky that we get paid to do it, Brian. We get to hang out and talk about it. For folks that listen in, we're always all ears for ideas and there are so many different ways to engage with us. If you're having trouble finding that community, just look out for us on social at Brian Feroldi. We're @MFIndustryFocus.

Brian Feroldi: Always love to talk with you, Dylan. Have a good weekend. Bye.

Dylan Lewis: You too, man. Listeners, that's going to do it for this episode of Industry Focus. Like I said, any questions, you can shoot them to [email protected] or tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people on program may own companies discussed on the show and the Motley Fool may have formal recommendations for or against stocks mentioned. So don't buy or sell anything based solely on what you hear. Thanks, Tim Sparks, for all his work behind the glass today and thank you for listening. Until next time. Fool on.