In recent weeks, rising interest rates have made bond yields more attractive, sparking a sell-off that hit the tech sector especially hard. While the tech-heavy Nasdaq Composite Index is down just 6% from its all-time high, many individual tech stocks have fallen much more.
Of course, this is nothing out of the ordinary. Bond yields represent a guaranteed rate of return, and as those rates tick higher, investors are more likely to buy risk-free U.S. Treasuries or other fixed-income securities. However, that doesn't mean you should abandon the stock market -- especially if you still have a decade or two before retirement. Stocks typically outperform bonds over long periods of time.
With that in mind, we asked three Motley Fool contributors to pick tech stocks that should generate solid returns in both high and low-interest-rate environments. Keep reading to see why Lemonade (LMND -0.73%), Netflix (NFLX 2.08%), and Take-Two Interactive (TTWO -0.14%) made the list.
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A disruptive insurance company
Trevor Jennewine (Lemonade): Lemonade brings the power of modern technology to the age-old insurance industry. Its digital-first platform leans on big data and artificial intelligence (AI) to cut costs and reduce friction for consumers. This gives Lemonade an edge over legacy insurance providers, which still rely heavily on human workers and outdated technologies.
For instance, the company replaces insurance agents with AI-powered chatbots. This creates a delightful experience for customers, making it possible to buy insurance in just two minutes and receive claims payments in as little as three seconds.
At the same time, this automation means Lemonade can operate with just one employee per 1,700 customers, while legacy insurers typically require one employee per 150 to 450 customers. Put another way, Lemonade's AI-powered business model keeps its payroll expenses low.
Building on that, Lemonade's platform is also designed to capture and deploy 100 times more data than traditional systems. That advantage means its AI models can (theoretically) quantify risk, underwrite policies, and detect fraud more precisely. In other words, Lemonade's loss ratio (i.e., paid claims as a percentage of earned premiums) should trend downward over time, eventually leveling off below the industry average. That means the company should keep more cash than its rivals.
So far, this theoretical advantage appears to be sound. In Q2 2018, Lemonade posted a loss ratio of 132%, but that figure fell to 74% in Q2 2021. For context, the average loss ratio for the entire industry was roughly 70% through the first half of the year. Lemonade still has work to do, but things are moving in the right direction.
As of the second quarter, Lemonade had 1.2 million customers, up 48% from the prior year. More importantly, as the company has expanded its product portfolio -- which now includes homeowners, renters, and pet insurance, as well as term-life coverage -- customers have added additional policies (or upgraded to more expensive ones), driving the premium per customer higher. In the second quarter, this metric came in at $246, up 29%.
Why is Lemonade a smart investment regardless of interest rates? Insurance companies make money when they underwrite policies but also generate income through investments. And in a high-interest-rate environment, the bonds held in Lemonade's portfolio should produce more cash. But in a low-interest-rate environment, the company's AI-powered business model should still be a disruptive force, helping it take market share in the multitrillion-dollar insurance industry.
A cash burner turned cash cow
Jeremy Bowman (Netflix): Not too long ago, Netflix was burning billions in cash to fund its content machine, and critics charged that the company would never be profitable. In 2019, the streamer reported negative free cash flow of $3.1 billion. However, that flipped to positive territory in 2020, thanks to the pandemic, and now Netflix isn't looking back. It can self-fund its growth from here on out.
Not only is it done borrowing, but the company is now a veritable cash machine. For the first half of 2021, Netflix's operating income has reached nearly $4 billion, and it expects its operating margin to increase by an average of 3 percentage points each year.
At this stage of its growth, Netflix also doesn't have the same vulnerabilities to rising interest rates that money-losing tech stocks do because investors can count on its cash flow in the near future rather than the distant one. In fact, Netflix stock tacked on 7% in September, even as the Nasdaq fell on jitters over rising interest rates. At one point, CEO Reed Hastings justified Netflix's borrowing, in part because interest rates were low.
There's another reason why rising interest rates actually favor Netflix. The company has $15 billion in debt that it racked up from its land-grab strategy of quickly building out its content library. Most of that debt, however, is low interest. The company is paying an average of 5% on those borrowings.
Netflix's debt is locked in at those rates, but its rivals, which may seek to follow the same playbook, will have to pay higher interest on debt if rates rise. This will make it more difficult to fund their content spend. While that process in the interest-rate cycle could take years to play out, it confirms that Netflix's earlier cash-burn strategy was a smart move.
Game on!
Eric Volkman (Take-Two Interactive): I'd bet top video game industry star Take-Two Interactive isn't keeping a nervous eye on the latest Fed moves. The company has a solid and dependably profitable business model and can fund most of its capital needs from internal sources.
Yes, Take-Two has some borrowings on its books -- who doesn't these days? But its long-term debt sat at just $157 million as of the most recent quarter, representing a mere fraction of its $3.2 billion in cash and short-term investments.
While Take-Two's profitability can be lumpy due to cyclicality in the gaming industry, the company has done a good job lifting its profit margin over time. Across the last five years, the figure has rise from 4% in 2017 to 17% in 2021.
What helps is that Take-Two has become quite adept at engaging its user base and getting them to spend money repeatedly. Its "recurrent revenue" derives, in its own words, "from ongoing consumer engagement and includes virtual currency, add-on content, and in-game purchases."
It's powerful stuff, too. Recurrent revenue increased 15% in the first quarter of fiscal 2022, accounting for 70% of Take-Two's top line. Were it not for that double-digit improvement, overall revenue would have suffered a deeper decline than the 2% it experienced.
Last year, Take-Two took its investors on quite a ride, as many piled into the stock in the thick of the coronavirus pandemic. This makes sense, as the company benefited from gamers stuck at home wanting to spend more on digital adventures.
Since then, many bulls have retreated, discouraged by recent (yet entirely understandable) slumps in certain key fundamentals, as the formerly self-quarantined emerge into the world.
The resulting price decline presents a fine opportunity to buy Take-Two stock at a relative bargain price. The company has some of the strongest video game franchises in history, namely the soon-to-get-a-major-update Grand Theft Auto and the durable and popular NBA 2K series. These titles alone give the company a long runway for growth, and Take-Two's development pipeline only supercharges that potential.
