In September, a write-up on Morgan Stanley's website was headlined, "Next Market Rotation Could See Value Stocks on Top." Now, some analysts are calling what's currently happening in the stock market "The Great Rotation" -- referring to the way investors have increasingly sold out of growth stocks to buy value stocks. And somewhere, investing legend Warren Buffett is cringing.
Because in his 1992 letter to Berkshire Hathaway shareholders, Buffett wrote:
Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." [...] We view that as fuzzy thinking [...] In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
When looking at investment options, it would be wise to keep these words from the Oracle of Omaha in mind. And these three growth stocks could be massive long-term winners.
1. Five Below
For all three companies under discussion here, I will acknowledge that their stocks don't look like good values now. But this is because they're prudently spending money to grow their businesses and earn more later.
Perhaps the clearest example of this is Five Below (FIVE 0.97%). The company operates a chain of discount stores targeted toward teens and preteens. It has grown from 625 locations at the end of 2017 to around 1,200 locations today.
Five Below says these stores cost around $300,000 on average to open. Therefore, over just the past four years, it's spent roughly $170 million to expand its store base. That's a hefty outlay, but consider these locations have an average payback period of less than one year -- Five Below stores generate $450,000 of adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) annually, on average.
As it has rapidly built out its footprint, Five Below's profits have unsurprisingly soared. In 2017, its full-year diluted earnings per share (EPS) were $1.84. For 2021, it expects to report EPS of at least $4.82 -- a 162% increase.
Five Below plans to keep expanding its store count to 2,500 locations. As long as its unit economics hold up, the company should keep growing profits at a red-hot pace, bolstering its chances to be a massive stock market winner.
2. Digital Ocean
DigitalOcean (DOCN -8.19%) provides both technology infrastructure and a technology platform primarily to small and medium-sized businesses. In this case, infrastructure refers to cloud computing and storage, whereas platform refers more to software. Both are huge, fast-growing markets. Management estimates that combined, these markets will grow at a 27% compound annual rate through 2025 to nearly $116 billion.
Large, growing markets invite competition, and there's no shortage of players in this space. That's why I like how DigitalOcean is spending heavily on research and development -- its largest operating expense. Through the first three quarters of 2021, it spent nearly $80 million on R&D. That might sound small compared to the budgets of large-cap tech companies, but it represents 43% of DigitalOcean's gross profit. It also increased R&D spending 46% year over year in that same period -- faster than its revenue growth rate.
To win market share in a crowded space, companies must stay ahead of the curve, and investing in R&D is one way to do that. That said, DigitalOcean is currently performing poorly when it comes to winning new business. At the end of the third quarter, it had 598,000 customers, down from 602,000 at the end of the previous quarter. Frankly, if its R&D spending was truly paying off as hoped, it wouldn't be losing customers.
This problem is real, and it might keep cautious investors watching the stock on the sidelines. There's nothing wrong with that. However, do be sure to keep watching, because there's a good chance this customer attrition issue is a short-term anomaly. Consider that DigitalOcean has added around 8,700 customers per quarter on average for the last six quarters, even factoring in the recent dip. For now, at least, the long-term pattern still suggests the company is building out a product suite that wins new business.
We'll see if DigitalOcean got back to customer growth in the fourth quarter when it reports on Feb. 24. If it did, that may be a sign the company is still on its way to capturing a major growth opportunity.
For e-commerce to function properly, you need to have a robust delivery system, something Latin America's MercadoLibre (MELI -1.63%) had limited access to when it started. Lacking infrastructure to work with, it has been steadily building its own.
MercadoLibre launched Mercado Envios, its logistics network, in 2013, and that year, it shipped just 10% of items ordered on the e-commerce platform in Brazil. Consider that in 2013, the company sold a total of 83 million items on its marketplace, and not all of those were Brazilian sales.
In 2021's third quarter alone, the company sold 260 million items, and 247 million of them were shipped via Mercado Envios.
Not only that, 80% of MercadoLibre's sales volume can now be delivered in 48 hours or less. More than half can arrive on the same day as they're ordered or the next day. These delivery times -- enabled by all of the points of distribution and fulfillment centers the company has built out over the past several years -- are helping to boost e-commerce adoption in each market.
However, that has been an expensive undertaking. Through the first three quarters of 2021, MercadoLibre spent $425 million on property and equipment -- one of its largest investments. But this spending paves the road for greater long-term adoption of its platform.
Trailing-12-month revenue has nearly quadrupled for MercadoLibre over the past three years. Growth like that wouldn't have been possible without those infrastructure investments.
The company's profits are currently meager, so it doesn't fit the classic definition of a value stock. But back to Buffett's 1992 letter, in which he also wrote, "The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return." I believe MercadoLibre is doing exactly that, and Mercado Envios is just one example of this.
For that matter, I believe Five Below, DigitalOcean, and MercadoLibre all have the potential to be the kind of growth stocks we're looking for. Other investors might regard them as overvalued, but today's investments should yield tomorrow's profits.