13 photonics stocks fell 42% while sales grew 20%.

Hey {{first_name|Investor}} -

As of September 3, a group of 13 optical networking stocks (the companies that make the lasers and fiber links inside AI data centers) sat about 42% below their 52-week highs on average. The S&P 500 was less than 1% below its high the same day.

All 11 of them that reported in August grew revenue more than 20% from a year earlier. Only 1 guided the next quarter below what analysts expected.

Sales up 20%, stock down 42%. Both are true at once, and if you don't understand how, every drawdown you ever live through will feel like the company must be broken.

A stock price is 2 numbers multiplied together: what the company earns per share, and how many dollars people will pay for each dollar of those earnings. That second number is the multiple, the P/E ratio you see on every quote page.

Written out: price = earnings per share x multiple. Every stock move you'll ever see is one of those 2 numbers changing, or both.

Think of a rental property. The rent is the earnings. The price someone pays for the building, divided by the yearly rent, is the multiple.

Rent can rise 20% in a year while the building sells for 40% less than it would have last year. The tenant did nothing wrong. The buyers in that neighborhood changed their minds about how many years of rent a building is worth.

A company earns $2 a share and trades at 50 times earnings. The stock is $100.

A year later it earns $2.50 a share, up 25%. But buyers now pay 30 times earnings instead of 50. The stock is $75.

The business grew 25%. The stock fell 25%. Nothing about the company's operations shows up anywhere in that drop. The whole move came from the multiple.

Investors call this multiple compression, and it's one of the most common ways a good company hands you a bad year.

3 things shrink a multiple even when the business is fine. All 3 hit optics this summer.

1. Interest rates went up. The 30-year Treasury has paid more than 5% since early July, and by September 1 it had traded above that line on 55 sessions this year, the most since 2006.

Back to the rental property. If a savings account pays 4%, a building yielding 5% in rent looks fine and buyers will pay a lot of years of rent for it. If the savings account moves to 5%, the building has to compete with a risk-free 5%, so buyers pay fewer years of rent for the same building. The rent didn't change. The alternative did.

Buildings whose big rent increases are years away get hit hardest, because buyers are waiting longer for money that now has a better place to sit. Most of the optics payoff from new chip-level designs lands in 2027 and 2028, which is why this group felt the rate move before the rest of AI hardware did.

2. The company is spending or raising money faster than it earns. Coherent ($COHR) spent about $1.1 billion building factories in its last fiscal year against $79.5 million of cash from operations, and sold about $2 billion of new shares to cover the gap. Applied Optoelectronics ($AAOI) has sold roughly $1.1 billion of new shares since March and filed to sell $600 million more in August. When several companies in a group grow sales fast while cash only goes out, buyers start pricing the whole group like a capital-hungry cycle rather than a software business.

3. Separate headlines get read as one. In August, NVIDIA said its new optical switch uses a quarter as many lasers. Fabrinet ($FN), a contract assembler, reported flat data center sales. Credo ($CRDO), a connectivity chip maker, reported a lower gross margin on one of its 2 reported measures. Those are 3 different companies at 3 different layers of the supply chain, and the market read them as one message that optical profits were shrinking everywhere.

Read one at a time, each one describes dollars moving from one layer to another. Fewer lasers, but each one far more powerful and expensive. Less assembly at one vendor, more at another. Read together, they looked like a collapse.

Before we continue to the 3 checks to make sure the business isn’t broken, here’s a word from today’s sponsor.

Gmail is free, but you pay with your data. Proton Mail is different.

We don’t scan your messages. We don’t sell your behavior. We don’t follow you across the internet.

Proton Mail gives you full-featured, private email without surveillance or creepy profiling. It’s email that respects your time, your attention, and your boundaries.

Email doesn’t have to cost your privacy.

Ditch the Gmail data grab

A falling price with a growing business is what gets me interested. On its own, it's never enough. Here's how I sort them.

Check 1: Is the business still growing, and did management raise or hold its forecast?

Pull the latest earnings release. Revenue growth and next-quarter guidance are on page 1. If both are up, the fall came from the multiple.

Ciena ($CIEN) is a clean case. On September 3 it reported revenue up 37%, adjusted earnings per share up 215%, and raised its full-year forecast. The stock fell about 10% that day. Business up, price down: that's a multiple story.

Check 2: Did the whole group fall, or just this name?

Open the charts for 4 or 5 companies in the same industry. If they all fell together on the same weeks, something changed about how buyers value the group (rates, a policy headline, a sector rotation). If one fell alone, look for a reason specific to that company.

Check 3: What is the specific worry, and when will the numbers confirm or kill it?

Every scary headline should reduce to a testable sentence. For Fabrinet, the worry is that NVIDIA's newest optical designs route assembly to other vendors; an analyst on its call noted NVIDIA revenue ran down 20% or more for the year. That's a real question. It also has a date attached: 2 more quarterly reports will show whether its data center line grows again or keeps sliding.

If you can't write the worry as a sentence with a date on it, you don't understand the drop well enough to act on it.

Credo is the better lesson, because the headline and the number underneath it disagreed. Companies report profit 2 ways. GAAP is the official accounting standard, and it includes items like stock-based compensation and acquisition costs. Non-GAAP is the company's own adjusted view with those items stripped out, which is the number management and analysts usually guide to and track.

Credo reported after the close on September 1. Its GAAP gross margin fell to 64.5% from 68.2% the prior quarter. Its non-GAAP gross margin was 68.0% against 68.3%, flat by any reasonable standard, and revenue grew 115% from a year earlier. The stock had closed at $206.63 that day; the next session it closed at $165.22, down 20%, with the GAAP margin line as the headline.

So the testable sentence is: does non-GAAP gross margin stay near 68% next quarter? If it does, the drop was an accounting headline. If both measures start sliding together, the business changed. When a margin headline hits, find both numbers before you react to either.

Write down the multiple you're paying. That's the habit this whole issue comes down to.

When I look at a company, I note its price divided by next year's expected earnings on the day I look. 6 months later, if the stock is down 30%, I check that number first. If the multiple did all the falling and the earnings estimates held, I'm looking at the same business at a different price, and the question I ask is whether my original reasons still stand.

If the earnings estimates fell too, the business changed, and I have to redo the work from the top.

That's the question I'm asking about my own entries in this group right now. A 42% average drawdown against 20% growth is the setup where the habit earns its keep, and it's also exactly where people who skip the 3 checks get hurt, because some names in any fallen group deserved to fall.

Zoom ($ZM) is the version that never came back. In late 2020 it traded at more than 50 times sales while revenue grew more than 300%. The multiple compressed over the next 2 years, which on its own would have been a reset. But revenue growth slid into the single digits by 2023, so the earnings estimates fell with the multiple. Both numbers in the formula moved the same direction. Buyers who saw the 80% drop and assumed the business was the same business were wrong, and the stock still sits far below its high 6 years later.

Rent went up. The building sold for less. Your job is to find out what changed the neighborhood.

Stay disciplined, Koh

Disclaimer: Nothing in this email, the Reset and Invest newsletter, the Make Your Own Alpha book, or any course or digital product from Starshine Media LLC constitutes investment advice or a recommendation to buy or sell any security. Numbers and observations are as of publication. I may hold positions in companies discussed. Always do your own research and consult a licensed financial advisor before making investment decisions.