A stock that I own, Arista Networks (NYSE: ANET), plunged by over 24% last Friday, 1 November 2019.
It was not pretty. You may have even experienced such a decline before. If you have, you would know that keeping our wits about us can be tough. Especially when our hard-earned money is on the line.
Given the ferocity of Arista Networks’ fall, I thought it is an opportune time to share my approach for situations like these using the company as an example.
1. Don’t panic
As a first step, we should always leave our emotions out of investing.
But that’s easier said than done. So, let’s talk about something real and doable. Thankfully, I have done two things that kept me calm despite the decline:
1. From the start, I sized my position in Arista Networks to something I was comfortable with.
2. I hold a cash position that I can use when a big decline happens.
These two actions, which form part of my investing process, provides built-in support for situations like these.
2. Focus on the business
Our source of pain is from the share price decline — that’s because our money is tied to the stock.
However, focusing on the stock price will not make our pain go away. The best way to figure out what is happening is to look at how the business is doing.
Going back to Arista Networks, the latest quarter’s results look healthy:
1. Revenue rose 16.2% while profits were up almost 24% year on year.
2. Free cash flow was about US$265 million.
3. The company also had US$2.45 billion in cash and marketable securities.
In short, Arista Networks’ business is as healthy as any investor could hope. So, why the angst, you might ask?
3. The pain point
When a major, one-day decline happens, there is usually a reason for the market’s displeasure. Our job is to find out what that bad news is, and what it means for the company.
For Arista Networks, it was probably its tepid forecast that had the stock market all worked up. The company was forecasting a 6% to 9.3% decline in revenue for the next quarter.
Like any company, there were risks to consider. Case in point: Arista Networks has two customers, Microsoft Corporation (NASDAQ: MSFT) and Facebook (NASDAQ: FB), that account for over 10% of its sales. It was a risk that I noted when I first bought its shares.
Unfortunately, the risk of customer concentration flared up in the latest quarter.
One of Arista Networks’ major customers, presumably Facebook, decided to swiftly reduce its purchases in the fourth quarter and for the year 2020. The end result was that Arista Networks’ sales growth will likely be flat or down through the rest of this year and next year.
There is no way around it. Falling revenue is bad, especially when the stock is priced for growth. In this sense, the stock price decline was justified.
4. Permanent or fixable
Identifying the problem is the first step. The next step is to figure out whether the issue is permanent or fixable. For the most part, this area is a judgement call.
In the case of Arista Networks, I believe that its current problem can be solved. Here are my reasons:
1. As a general trend, I believe that data usage will continue rising. The supporting infrastructure, which Arista Networks provides, will be in demand.
2. The major customer that was pulling back decided that it wasn’t getting good enough returns to upgrade its hardware right now, and might wait for the next generation of switches.
3. Speaking of the next-generation, Arista Networks has 10 new models of its 400G switches available in the market. Originally, the company had thought that it could ramp up production in the second half of this year. However, the ramp-up has now been delayed by a year, as the market is not ready for an upgrade.
5. Don’t forget the positives
As investors dig into the negatives, what I have found is that they often miss out on the positives.
Always remember why you bought the shares in the first place. And check whether those reasons still exist. In my case, I have noted that:
1. Arista Networks’ management team, which includes its founders, have led the group since 2004 and continue to be heavily invested in the success of the company.
2. Free cash flow remains very strong. The company also has US$2.45 billion on its balance sheet.
3. The company’s product strategy remains the same, emphasizing its software over generic hardware.
In my experience, a management team with a strong track record and money in its hands is a strong hand to have.
6. Knowns and unknowns
As we piece together the full picture, knowing what we don’t know and acknowledging what we will not be able to know is important.
What we know today is that a major customer has pulled back from purchasing from Arista Networks. What we don’t know is when the client will decide to buy again. This risk will always remain with Arista Networks.
There could be other explanations of why there is an expected revenue decline.
Networking hardware can change every 18 months, and I am reliant on the management team to stay ahead. There could be new products and competition. These are things that we won’t know all the details.
As investors, we have to cater to the unknown unknowns as we make our decision on how much to invest in a particular company.
7. Get Smart: What should investors do?
All of the above is a gradual buildup to help us come to the best decision we can make, given what we know.
Shares of Arista Network look cheap today because of its uncertain near-term future. I would argue that if everything was working well for in its business, then its stock will not be cheap.
Arista Networks is not in financial trouble. In fact, the company is cash rich. Instead, the question is whether it can return to growth.
For that, there is no clear cut answer. So, what is a Smart Investor to do?
To come to a decision, I would like to provide three guidelines you can use:
1. Buy because you want to own more of the stock, not because the stock price dropped. Maintaining the right allocation keeps your emotions in check which will be important for your future decision making.
2. Always remember that you don’t have to pour in all of our money into one stock at one moment of time. As investors, you can always wait for the next quarter or more before deciding. Likewise, we can add a little today, and wait for more information before adding more in future.
3. Don’t forget that there could be other opportunities beyond what you are looking at right now. You don’t have to do something every time a big decline happens.
For me, my position in Arista Networks is still small relative to my total portfolio. As such, I can choose to add to my position today and leave the option to add more in the future.
I hope that by sharing my thought process, it can help you think through your own situation when you are faced with a stock that has fallen significantly.
Even the biggest winning stocks will fall from time to time. But you don’t have to be scared if you have the right mindset and know what to do. Good luck.
None of the information in this article can be constituted as financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Disclosure: Chin Hui Leong owns shares of Arista Networks and Facebook.