High growth stocks have been getting crushed. The rhetoric on Wall Street is that higher interest rates are the culprit. That’s partially true, but there are multiple catalysts in play.
Higher interest rates certainly aren’t helping the discussion right now. But a nasty case of rotation is only adding salt to the wound. Investors are dumping tech and specifically, high growth stocks as they rotate into reopening trades, financials, industrials and other value plays.
It also doesn’t help that growth investors can be a bit blinded to risk as well. Meaning they leverage up on their holdings as their rise over months and/or quarters, before a quick flush down forces many of these investors to liquidity their holdings.
Case in point, the Archegos Capital situation only underscores this risk. When Baidu (BIDU), ViacomCBS (VIAC) and others were flushing lower, the action didn’t look normal.
In fact, in the Pro Trading Chat Room — the same day traders were calling for that huge late-day spike in the S&P 500 futures — I said it feels like there was forced liquidation during the session. Something wasn’t right.
Obviously high valuations — like we see with Shopify (SHOP), Twilio (TWLO) and The Trade Desk (TTD) — don’t help either.
So when I say there are several catalysts helping to drive these stocks lower, this is what I mean. How long it lasts, nobody knows. But there are opportunities here for the patient investor.
Dissecting the Breakdown in Tech
As we saw in the fourth quarter of 2018, higher rates are not good for the stock market — especially when it’s unexpected.
This time around is a little different, though. First, it’s disproportionately impacting high growth tech. While this group didn’t fare that well in Q4 2018, neither did the S&P 500 or Dow Jones. The pain was limited to just the Nasdaq.
Currently, the S&P 500 and Dow are continually hitting new highs.
The difference then was that the Fed signaled a higher-rate environment. That is to say, it was turning hawkish. Currently, the Fed couldn’t be more accommodative, while Powell & Co. have signaled that it will remain that way for a while.
To a degree, that underscores the rate discussion. It’s not good for high growth stocks, but consider where rates are historically. They’re still incredibly low — plus the data doesn’t suggest the spike in the 10-year is in the end of the world.
As for rotation and being over-levered, well, there’s not much investors can do about that. The rotation game can last for days, weeks or even months. Patient investors need to simply wait for their time to strike.
Finally, there’s valuation. When a stock trades at 40 times revenue, I’m sorry but it’s going to be susceptible to a big haircut when the selloff finally comes. That doesn’t mean it can’t double or triple beforehand though.
At the end of the day, high growth stocks with great business models don’t come at a discount. These valuations fly higher and higher despite the criticisms, and they “don’t matter” until this group is done taking the escalator up and starts taking the elevator down.
That’s when the valuation suddenly starts to matter.
When to Buy High Growth Stocks
So that boils down to the question of, when do we buy high growth stocks? There are two things investors need: Patience and a draw to quality.
Investors either need to accumulate these stocks with the understanding that the bottom could be in 3 to 5 days or in 3 to 5 months (or more).
If investors aren’t into the idea of accumulating, they’ll need to patient for the all-clear signal we get when there’s a bottom. Picking bottoms is too hard (for me), so instead I like to go with the accumulation route.
In the growth world, there’s something known as the “rule of 40,” which is a combination of EBITDA margins and revenue growth. For me though, the “rule of 40” is simpler: Wait for high-quality, high growth stocks to decline by 40%. Then start to dig in.
It’s a rough rule of thumb — just like the actual rule of 40 — and it’s not perfect. But it at least gets investors in after a deep discount. Go back and look at Apple or Amazon or any other great growth company when it was smaller and younger. 35% dips were common enough to happen every few years, but not common enough to happen every few quarters.
Had investors just bought those deep dips and sat tight — instead of running scared — they’d be in a great position all these years down the road.
That’s why I’m looking at Roku (ROKU), Pinterest (PINS), The Trade Desk (TTD) and others. Eventually these high-quality winners will be loved by Wall Street and when that time comes, you’ll wish you had warmed up to these names when they were hated.
