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Why Investors Increasingly Support Innovative but Unprofitable Companies

By Keith Noonan – Jul 16, 2020 at 6:30AM

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No profits? No problem. Growth is crushing value in this year's volatile trading environment, and the trend could continue.

The investing world has changed a lot over the last decade, and 2020 is on track to be a year of particularly dramatic shifts. Many companies and investment strategies that once produced strong, dependable results are losing popularity, and investors are increasingly favoring innovative businesses with growth-dependent valuations over those with low earnings multiples and big dividends. 

Tesla (TSLA 1.72%), for example, has never had a profitable year, but its stock has climbed roughly 269% thus far in 2020. Meanwhile, General Motors and Ford have each lost roughly 30% of their value despite posting much higher sales and earnings. It seems clear that the market is going gaga for growth -- here's why this big shift is occurring.

A person holding a light bulb with gears and a brain inside.

Image source: Getty Images.

Growth stocks are outperforming value stocks

Conventional investing wisdom holds that when times get tough, companies with relatively low price-to-earnings and price-to-sales ratios tend to hold up better than companies with highly growth-dependent valuations. That certainly hasn't been true amid the volatility created by the coronavirus pandemic in 2020. 

Take a look at the performance of the Nasdaq-100 Technology Sector Index compared to the Russell 1000 Value Index this year:

^NDXT Chart

^NDXT data by YCharts

The difference is similarly stark over longer periods. Nasdaq's tech-focused index is up roughly 174% over the last five years and 357% over the last decade, while the Russell 1000 Value Index's level rose just 10.5% and 59% over the same time periods.

Investors' rising preference for innovative, tech-driven companies is easy to understand in this context. 

The market is more forward-looking than ever before

Investors are looking for revolutionary companies that will change how the world operates and deliver huge returns along the way. That's been the winning approach to stock picking over the last decade, and the potential that innovative technologies have to inform, impact, and reshape huge cross-sections of business and everyday life suggests that it will continue to be the best way to achieve market-crushing returns in the future. 

After soaring roughly 500% in five years, Tesla's market cap stands at roughly $286.5 billion. That's more than 4.5 times the combined market caps of GM ($35 billion) and Ford ($24 billion). The electric-vehicle specialist's stellar performance this year, despite major headwinds in the automotive market, highlights investor confidence in its innovation and long-term growth strategy. 

Tesla isn't the only transportation-adjacent company with disruptive potential trading at a premium relative to its fundamentals. The losses that Uber (UBER 1.70%) has racked up since going public roughly a year ago are daunting at first blush, but many investors who are backing the stock are likely taking the long-term view, imagining the performance it could achieve if it maintains its market-share leadership in ride-hailing and food delivery while benefiting from advances in self-driving vehicle technologies. 

Virgin Galactic (SPCE 4.70%) might be the single best example of the market's heightened preference for innovators with explosive long-term growth potential. Last October, it became the first consumer-space flight company to go public, and it's valued at roughly $4 billion based on today's stock prices. If you think about the vastness of space and its potential, that valuation might not initially seem all that remarkable, but Virgin Galactic is currently trading at roughly 916.5 times this year's expected sales.

Traditionally "safe" stocks aren't as safe as they used to be

Management at automotive giants such as General Motors and Ford put substantial effort into making their companies more financially sturdy after the Great Recession. However, both companies now face a different kind of crisis that features supply-chain disruptions and significantly weaker consumer demand -- and both have cut their dividends in response. GM and Ford have made substantial investments in electric vehicles and autonomous driving systems, but the market clearly prefers Tesla's brand and tighter focus on disruptive technologies. 

Value investing is being turned on its head. With a likelihood of tough economic conditions in the near term and disruptive innovations in the medium term, some energy and infrastructure stocks that once looked like safe plays must be reevaluated in the context of complex new variables. Meanwhile, brick-and-mortar retail companies that looked like bargains based on valuation metrics now face even more pronounced headwinds due to the operating conditions created by the pandemic.

Stocks might offer attractive yields or low price-to-earnings ratios, but there are often good reasons to be skeptical about the long-term outlooks for their underlying businesses. Companies posting strong sales and earnings still risk trending toward irrelevance if they don't map out and execute sufficient innovation strategies. 

The playing field is changing, and investors have to change with it. The massive stock gains of Tesla and other growth-dependent stocks reflect a belief that innovative technologies and business models will shape the market in the coming decades. Some highly growth-dependent companies will inevitably fall short of expectations, but the general thesis looks like a safe bet. 

Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla and Virgin Galactic Holdings Inc. The Motley Fool recommends Uber Technologies. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Tesla, Inc. Stock Quote
Tesla, Inc.
$287.81 (1.72%) $4.87
Uber Technologies, Inc. Stock Quote
Uber Technologies, Inc.
$28.04 (1.70%) $0.47
Virgin Galactic Holdings, Inc. Stock Quote
Virgin Galactic Holdings, Inc.
$5.12 (4.70%) $0.23
Ford Motor Company Stock Quote
Ford Motor Company
$12.18 (2.27%) $0.27
General Motors Company Stock Quote
General Motors Company
$35.25 (1.56%) $0.54

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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