This may sound like a fairytale, but it could have an unhappy ending.

Robinhood is the US stockbroking app that has driven an influx of literally millions of (particularly younger) investors who have bought American stocks on a fractional ownership basis.

Fractional ownership is the same principle that Easy Equities uses locally, which allows people to invest a specific amount of money in a company vs. having to pay the full price per share.

For example, if a share price is $100, then you would normally need at least $100 to be able to buy a share in that company. Under fractional share ownership, you could invest only $10 to hold 10% of one share. It suddenly opens the market up to the masses as you can invest your lunch money in a company you like.

Fractional ownership is brilliant because loads of people have now developed a genuine interest in investing. I love what Easy Equities has done for the local investing community. The key difference between Easy Equities and Robinhood is that Robinhood allows you to buy shares on margin whereas Easy Equities does not allow you to make any leveraged trades.

In other words, Robinhood can lend you money to buy shares. Easy Equities does not offer this service.

This takes a risky pastime and turns it into gambling, particularly because Robinhood investors are anything but experienced. Easy Equities is an investing tool, but Robinhood is a trading tool that in my opinion creates significant risk for everyone in the market.

Let me explain why you need to be aware of the Robinhood risk.

Stock splits: pulling the hood over your eyes

Apple and Tesla recently implemented stock splits. This simply means that each share is split into a few shares, such as five shares for every share currently in existence.

It changes nothing about the company’s fundamentals. If you hypothetically owned 1 share worth $100 before the split, you now own 5 shares worth $20 each.

However, because many brokerages don’t allow fractional ownership, it is far easier for retail investors to buy one $20 share than it is to buy one $100 share. The increase in demand suddenly drives the share price, so the 5 shares strangely jump to be worth $25 each, or $125 in total.

By splitting the stock, there’s a 25% price increase in this example. I deliberately call this a “price increase” and not “value creation” because there is no value created here. This is a short-term phenomenon that could turn around quickly.

Despite Robinhood traders being able to already use fractional ownership as a way to buy Apple and Tesla without paying the full share price, the stock splits for both companies caused Robinhood’s systems to crash. There was massive demand for the stock split as retail investors climbed in.

It defies logic.

Fairytale valuations

Global tech stocks represent a significant percentage of my portfolio. This isn’t because of the general hype, but because I genuinely believe the world’s leading tech companies are in an almost unassailable position and are generating substantial cash flows.

There are two popular stocks that I specifically do not hold: Netflix and Tesla.

I think that Netflix is just an expensive media company. Subscribers grew terrifically over lockdown and margin improved, but this was a perfect situation for Netflix: people were stuck at home and happy to consume old content, while Netflix couldn’t incur any costs in producing new content because of lockdown anyway.

I’ve written about Tesla before, but I find the entire situation to be nonsensical. I struggle to even define a car manufacturer as a tech company, even if Tesla is supposedly ahead on electric vehicle (EV) technology vs. the Germans.

The reality is that Tesla doesn’t exist in a competitive bubble. As EVs grow in popularity, the world’s most successful manufacturers will turn the EV taps on. Tesla may enjoy cult status in California, but the brand isn’t going to unseat the likes of Mercedes-Benz or Porsche anytime soon on a global level.

It’s critical when investing in tech companies that you don’t let the hype consume you. Tesla is trading at a valuation that can only be justified if Tesla becomes the most profitable car company in the world.

Frankly, I would rather bet on a swift end to load shedding and we all know what the odds are of that.

The Robinhood dump

The trouble in the market is that the shares are now held by inexperienced, panicky investors who will run at the first sign of issues.

The Nasdaq-100, the primary tech index, suffered a significant sell-off last week. It closed on Friday around 6% down from Wednesday. Volatility is heightened by the presence of investors who are more likely to sell when things look shaky.

At one stage in intraday trading, Tesla was down a whopping 25% last week.

Most interestingly, there wasn’t a specific catalyst for this sell-down. There’s obviously a broader concern about the economic environment, but it’s a problem when an index can drop this sharply without an identifiable reason for doing so.

Tesla fell by a quarter off little more than stock market jitters. What do you think will happen if Tesla reports lower than expected earnings? What will the Robinhood crowd be forced to do with their shares that they borrowed money to buy?

I think they will dump the stock and the price will drop significantly.

Common sense should still prevail

Long-term, I believe that everyone needs to have tech exposure. It’s not the future; it’s the present. However, investing in this sector doesn’t mean that common sense and fundamental principles should be ignored.

If you stick to the basics and invest in companies with competitive advantages, strong growth prospects, attractive cash flows and reasonable valuations, you’ll be ok.

If you buy into the hype, you may be dumped by the Robinhood wave.

Listen to your gut feel and be led by your investing principles. If it seems too good to be true, it probably is.

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1 Comment

  • Duncs
    Posted Sep 7, 2020 at 10:37 pm 0Likes

    Interesting take on fractional share ownership and volatility. Secondly – although Tesla is probably a bit overvalued currently, it’s got a strong new age brand and following globally with people who aren’t old school car brand mad, so think you’re a bit wrong there!

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