School started last week, so let’s get to our investment lesson of the day, an autopsy of a stock’s collapse. We don’t want to pick on any particular stock here, but we’ll use a recent example. Essentially, we want to find out what happened to cause a stock to decline 91 per cent in a period of six months, which translates into a market-capitalization drop to $501 million from $5.7 billion.

After some study, we concluded that the real question isn’t why the stock fell so much, but why it was worth nearly $6 billion in the first place. In our opinion, the stock should never have been at that level. There were some reasons for the rise, but some big warning signs for investors as well. Let’s take a look at the rise and quick collapse of Facedrive Inc., which trades on the TSX Venture.

No analyst coverage

Even with a growing company valued at more than $5 billion, no analyst on Bay or Wall Streets had ever covered the company. We prefer companies with little coverage (so they can be bought cheaply), but, at a certain point, the lack of analyst coverage becomes more of a concern. Why are analysts not covering the company? Is there something in the fundamentals we can’t see? Do the analysts have a negative history with management?

Analysts are driven by commissions/fees, and Facedrive has not done a lot of financings where it has paid investment bankers. Many deals were done privately. But analysts can still score points with customers by highlighting a fast-growing company. Facedrive shares rose to more than $60, from less than $2, in under two years, yet no analyst hopped on board during that heady time.

An extremely tight share float and weak liquidity

Close to 80 per cent of Facedrive’s shares are very tightly held by company executives and some numbered companies, according to the data we have. Thus, when there were buyers — and there certainly were over the past year — stock was very hard to find. Buyers needed to pay higher and higher levels if they wanted to own shares. There have been 16 trading days this year alone where the stock rose more than 10 per cent, and it jumped 22 per cent and 27 per cent on a couple of days. The stock also more than doubled during a one-week period in February.

A tight share float can be a fabulous thing for shareholders when things are going well. But, of course, the opposite is true as well. There are few buyers when momentum turns negative, and stocks can drop just as fast, as has happened to Facedrive’s shares recently.

Hot sectors and promotional press releases

Facedrive has been involved in many different types of businesses: ride sharing, food delivery and COVID-19 contact tracing, just to name a few. At various times over the past two years, these sectors have been hot, or very hot. Facedrive investors were clearly excited by the prospects of a new emerging company within several fast-growing sectors. And the company made sure there were plenty of nice press releases along the way to keep investors focused on developments.

Now, we have nothing against press releases, but they cost money. Not all releases were that material to the company, but without any analyst coverage, the company needed to get “news” disseminated to investors.

Weak fundamentals and extreme valuation

We also have nothing against expensive companies, and they sometimes make the best investments (when the valuation is justified). But even we have our limit on valuations.

In May, the company reported that its first-quarter sales were $4.2 million, sharply up from the prior year. That’s great. But, at its peak valuation, if we annualize and add some growth, the stock traded at about a 224 price-to-sales valuation. Since it is not making money, we can’t use price-to-earnings ratios. We then screened 21,000 companies in North America (all above a $500-million market cap), and found just 41 companies that had a higher price/sales valuation than Facedrive had at its peak.

Prior executive history and, now, executive departures

Facedrive’s management team has been involved with some other public companies. We like to see prior experience. Not every executive has to have a perfect track record (good lessons can be learned from failures as well), but the track record here of the executives’ prior ventures was not great.

This doesn’t mean new ventures will fail, but it should have at least kept Facedrive’s valuation in check a bit, at least until its long-term growth was far more assured. In other words, if the jockey on the horse you are betting on keeps falling off, maybe let them finish a race or two before betting on them again. But our point is somewhat moot, as it was announced that several executives, including the chief executive and financial officers, were leaving the company, causing the stock to drop further.

Class over.