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“Nothing is as important as we think it is.”
– Daniel Kahneman
To briefly recap, a bug in a CrowdStrike (NASDAQ:CRWD) update caused a massive Windows outage this week, resulting in the company’s shares falling by roughly a third, ratings being downgraded and its price dropping, and sparking debate over cybersecurity protocols, ramifications, and network system vulnerabilities.
Dramatic changes in stock prices are difficult to evaluate and often result in a mismatch between fair value and reflected price. Many investors experience a fight or flight response, resulting in unwarranted selling due to herd behavior and defensiveness of what they perceive as their turf, as they hold tightly to a sinking ship.
The difference between these two is whether we are acting on an emotional response – a sinking ship or a ship being hit by rough waves.
In this article, we explore the psychological tricks the ocean plays on us in these situations, especially with the sounds of boats, waves, and sirens.
Ocean
Cybersecurity is one of the seven trends that will define the 21st century. It is at the center of the “data dilemma” of balancing privacy concerns with the valuable benefits of leveraging data. Until my last portfolio review, I hadn’t found a way to meaningfully touch on this trend.
Despite its many flaws, this bug proved CrowdStrike’s reach and impact. This can be considered a destructive test where a proof of reach limits the scope of the attack, but Microsoft (MSFT) has not limited the reach or access of the attack. This contradicts that assumption and further demonstrates the strength of the defensive wall CrowdStrike has put up.
The space is not without competitors: This week, Alphabet (GOOG)(GOOGL) was turned down in its attempt to acquire Wiz for $23 billion. This demonstrates the importance of cybersecurity and the vigorous competition, but it also shows the high value the market places on cybersecurity excellence. As long as the pessimism continues, CrowdStrike may be lacking that.
ship
Short interest in the company spiked after the report was released. While short interest has been declining as prices have fallen, it’s still higher than normal and could signal more pain is on the way.
Data by YCharts
In the wake of CrowdStrike, Bank of America lowered its price target on the stock from $400 to $365 but maintained a buy recommendation. HSBC lowered its price target on the stock from a buy recommendation to $302 from $388, KeyBank cut its price target to $300 from $420, and Barclays cut its price target to $285 from $400.
Even the most pessimistic outlook is very optimistic compared to the current share price of $255, which shows that while the market has taken a sharp hit as the stock price has fallen, we remain bullish on the company’s medium-term prospects.
This is in line with IBKR’s most active list, with CrowdStrike coming in at number three, signaling a buy-low stance.
evaluation
In the short term, we are seeing some fluctuations in earnings expectations, but in the longer term we are seeing a decline in expectations.
Revenue and FCFE Estimates (My Charts)
Earnings estimates only reflect operating results: for example, the company’s EPS last year was $0.37, but is shown here as -$0.03, reflecting non-operating interest income worth about $150 million, among other adjustments.
Gross profit margin estimate (My Chart)
Gross margins are projected to improve in all cases, with some improvement in the high forecast range, but nowhere near as dramatic. Profit margins are a different story, with big differences across scenarios: they reach nearly double digits in the high scenario, while the low scenario is barely profitable (adjusted) by 2026.
Revenue and EPS forecasts (My Charts)
Comparing my “normalized” EPS forecast with the market, I can see that while revenue expectations are in line, normalized EPS is significantly more pessimistic than what was reported.
EPS and Revenue Forecasts (Seeking Alpha)
Free cash flow used in valuation is still adjusted to take into account the performance of the non-operating core business. The main adjustment is a reduction in other operating funds, which mainly consists of stock-based compensation and deferred revenue. This appears to be the best choice to avoid overstating the company’s cash positivity in the near term.
FCFE – CRWD Estimates (My Charts)
With these changes to reduce EPS and FCFE, we get the following values, and we can see that the upside in the high-end scenario is huge, consistent with our optimistic pre-bug expectations for the stock. However, we’re no longer there. The stock still has room to fall in the mid-end scenario, but would be significantly overvalued in the low-end scenario, reflecting an inability to scale as well as it has in the past.
Fair Value Estimates (My Chart)
For now, it’s hard to find any new optimistic aspects for the stock as the dust has not settled, so it’s interesting to see where the optimistic range has been in the past, but we need to focus on the mid-to-low scenario.
Siren’s Call
There are two very clear groups in this situation: Group 1 are the people who got caught holding onto their shares, and Group 2 are the people who now see this as an opportunity.
Those holding stocks will typically have a fight or flight response which will trigger selling and irrational holding. Those who see this as an opportunity will need to determine if this is a falling knife situation or a “once in a lifetime” opportunity caused by irrational selling, and there will always be the fear of missing out.
Data by YCharts
The surge in trading volume is impressive, but the number of shares traded that day was about 160 million, about 65% of the shares outstanding. This is a big number, but even if every share traded only once, this shows the strong faith of the original shareholders, who chose to fight rather than run.
This is a sign of confidence in the stock, which is a good thing, but it is also possible that this confidence could fade and the share price could fall. Current holders are likely feeling regret for not selling sooner, and this mindset often leads to a “payback” mentality, where the price for selling the stock is arbitrarily set, such as “when it reaches the price you originally bought it at” or “when it reaches the same price as when the bug occurred.”
It’s impossible to know how widespread this sentiment is among current holders, but given the sharp drop in the stock price and the relatively low number of shares outstanding, I believe holders are reacting more emotionally than rationally.
All of these are important when evaluating options in Group 2. Understanding the key figures can give you a clearer picture of how solid the ground is and what kind of volatility the share price may have.
The only caveat that may not be as significant considering the “small” short interest is the dead cat bounce. When short sellers buy shares to liquidate their holdings, the stock price can spike. Many confuse this event with a stock price rally, and FOMO feelings run wild.
Conclusion
CrowdStrike’s defenses appear strong enough to withstand a single blow: key customer and holder confidence is encouraging, and fair value is relatively close to current price levels. However, the lack of near-term catalysts, above-average short interest, and relatively low trading volume (given such extreme circumstances) may indicate a slow recovery.
This may be a solid stock, but it’s still priced above its fair value. With this in mind, there are plenty of strategies to build a position and more than enough reasons to exit.
Let’s take a look at Tortoise and Cat’s portfolio outlook.
Tortoise Portfolio: True to the family motto, we are waiting to see. Yes, the stock is attractive and cyber security is a key trend for the next few years, but it is not the only player, and the current price and conditions are not achieving the key priority of lowering maximum drawdown.
“Good things come to those who wait”
A longer-term price could be considered once plans to get back on track are clearly detailed and guidance is solidified. These conditions could suggest the stock could trade higher than its current price, but a risk-averse portfolio would have no problem paying a premium for reduced risk rather than suffering through volatility.
The Cat portfolio jumps into a position full stop with protective puts in place. FOMO is a design flaw in this risk-oriented portfolio, but it is protective and not something to ignore. The portfolio recognizes the volatility of stocks and the risks they face in the short term. This strategy mitigates FOMO and takes a long position against the volatility that may come along if stocks go either way.
In my portfolio, I intend to make decisions based on valuation, and with the valuation I used, I believe the fair value of this stock is around $240-245, and considering the risks and alternatives, I would be better off taking a half position if it reaches this range, and completing the position if it reaches even lower values with growth prospects intact, or if it is on a clear trajectory due to less uncertainty and less risk.
Going back to my favorite Charlie Munger quote:
The big money isn’t in buying or selling, it’s in waiting.
-Charlie Munger
Stocks will be in the spotlight this week. Waiting a little longer seems like a wise choice. Waiting would be betting that current holders will run out of patience, the stock price will not recover (outside of a dead cat bounce), and a better opportunity will present itself to buy shares or gain exposure to the cybersecurity trend.
