Attention, Growth Stock Investors: Price Matters

If you can find the next Amazon.com or Apple early enough, the price you pay for the stock doesn't matter all that much. The main thing is that you're right about the company's growth potential.

This is not the same as saying price doesn't matter at all. For the past few years, and especially in 2020, buying the fastest-growing stocks without any regard for price has led to spectacular returns. Software stocks, electric car stocks, e-commerce stocks, and tech stocks in general have soared.

That situation has not remained true in 2021. The priciest growth stocks have been hammered, even though nothing has really changed in the underlying growth stories.

SNOW data by YCharts

Price matters. There are long periods where it doesn't seem that's true. The lead-up to the dot-com bubble is one example. 2020 was another. But price always matters in the end.

Buying shares of good companies and holding them for a long time is a great investment strategy. It works, but only if the price you pay is reasonable relative to the company's growth prospects. A great company can be a great investment at one price and a terrible investment at another.

Great companies, awful results

Microsoft (MSFT 0.46%), Intel (INTC 0.61%), and Cisco Systems (CSCO -0.37%) were great companies back in 1999, and they're great companies today.

Microsoft is dominant in PC operating systems and productivity software, and it's now the No. 2 player in the cloud infrastructure market. Intel was the leader in PC and server chips 20 years ago, and it's still the leader today. And Cisco is the largest provider of enterprise networking hardware by a long shot.

In 1999, Microsoft's revenue jumped 29% to $19.7 billion, and its net income soared 73% to $7.8 billion. By 2020, revenue had reached $143 billion, and net income had rocketed to $44.3 billion.

In 1999, Intel's sales rose 12% to $29.4 billion, and net income was up 21% to $7.3 billion. In 2020, Intel produced revenue of $77.9 billion and net income of $20.9 billion.

In 1999, Cisco's revenue increased 43% to $12.2 billion, and net income jumped 56% to $2.1 billion. By 2020, revenue had hit $49.3 billion, and net income was $11.2 billion.

Image source: Getty Images.

If a time traveler had laid out these numbers for you in 1999, you would have thought investing in these stocks would be a sure thing. You would have bought these stocks thinking they would easily earn you market-beating returns. You would have been dead wrong for nearly 20 years, and mostly wrong after that.

Microsoft stock only overtook its dot-com bubble high a few years ago, while Intel and Cisco stock still haven't. If you had bought each stock at the beginning of 2000, not quite the peak, here's how you did, excluding dividends:

Data source: YCharts.

Only Microsoft beaten the S&P 500 index, and it took almost 20 years for that to become the case. Intel and Cisco have lost badly to the index, even though both companies have remained dominant and grown both revenue and profit considerably. Instead of listening to the time traveler, you should have just bought an index fund.

Growth, but not at any price

A list of today's top growth stocks might include cloud data software provider Snowflake (SNOW 1.21%), connected fitness company Peloton (PTON 0.66%), payments company Square (SQ 1.68%), electric-car phenom Tesla (TSLA -3.40%), and e-commerce giant Shopify (SHOP 1.26%). Valuations are extreme, to say the least, even after the recent sell offs.

Data source: YCharts, Shopify Q4 report.

Of course, valuation metrics vary across industries, particularly the price-to-sales ratio. For software companies, Microsoft's dot-com peak price-to-sales ratio was less than half of what Snowflake's is today. For car companies, traditional automakers generally have a price-to-sales ratio below 1. No matter how you slice it, these stocks are expensive.

Some stocks that seemed obscenely valued during the dot-com bubble have gone on to produce fantastic returns. Amazon may be the best example. But that was not the standard result. If you were lucky enough to only invest in Amazon back then, you've have made a killing. But if you spread out your investments among a bunch of companies that seemed to have great growth prospects, the picture is more muddled.

Can these high-flying growth stocks produce market-beating returns over the next 20 years? Some of them probably will. But not every stock is the next Amazon. Even if these companies continue to grow quickly, their stock charts could end up looking like Intel's or Cisco's. When valuations are this high, you can be right about the company but very wrong about the stock.

Price matters.