The past few months have been a gut punch for those invested in pricey growth stocks. The same stocks that doubled, tripled, or even quadrupled in the early days of the pandemic are now being decimated as the pandemic wanes, inflation soars, supply chains buckle, and Russia's invasion of Ukraine roils markets.
The damage to high-flying tech stocks is widespread and severe. Here are some highlights.
It's not a pretty picture.
Valuations are still extreme
Some may view these declines as irrational. Even though demand at some tech companies is slowing down from pandemic highs, many of these companies are still posting solid double-digit growth. In some cases, there's been no real slowdown at all. Cloud computing provider DigitalOcean (DOCN 1.44%) and edge computing company Cloudflare (NET 0.94%) are two examples.
It's important to remember that valuations toward the end of last year as many of these stocks peaked were stratospheric. Price-to-sales ratios for some of these companies were 40, 50, 60, or even higher. And many aren't yet profitable.
A few years ago, a price-to-sales ratio of 20 for a fast-growing software company would have seemed expensive. By mid-2021, that kind of valuation was not only ordinary, but on the low side.
Because valuations were so high to begin with, even dramatic declines have left valuations at elevated levels. Cloudflare still trades for nearly 40 times sales; Zscaler at 30 times sales; Shopify at 14 times sales. Zoom has dropped all the way down to a P/S ratio of 7, but the pandemic darling expects sluggish growth and a steep profit decline this year.
For some of these stocks, the bottom could still be a long way down.
Inflation is not going to help
Inflation is complicated. It affects different companies in different ways. Some companies have pricing power and can pass higher costs on to customers, but those customers may pull back regardless of pricing because of economic uncertainty. And companies without much pricing power will have a much tougher time keeping the bottom line afloat.
Inflation also has an impact on stocks. Growth stocks tend to do worse in inflationary environments, but not entirely because of inflation's effects on the underlying companies. One explanation is that growth stocks look less impressive when inflation provides "free" growth to slower-growing companies.
When inflation is close to zero, mature companies aren't going to be growing much faster than the economy as a whole. A company that sells consumer products with strong brands may be able to muster low single-digit growth. Meanwhile, a software company growing at 30% looks great in comparison.
When inflation ramps up, mature companies with pricing power can boost prices to compensate. That consumer products company may be able to grow revenue by 10% annually if inflation is running at 7%. The software company may be able to boost pricing as well, but now the comparison is much less flattering. Why pay through the nose for an unprofitable software stock when you can get solid growth, profits, and a dividend for much less?
Of course, there are other factors that impact investors' decisions. But it's safe to say that inflation is not going to be a positive for the priciest of stocks.
Prepare for opportunity
The kind of broad selling that's happening with growth stocks right now is painful, but it will likely create some great long-term opportunities. Some stocks are selling off due to poor results, but others are getting washed away for reasons unrelated to the underlying company's financial performance.
At the right price, DigitalOcean and Cloudflare could be great long-term investments. DigitalOcean is a small player in the cloud computing market, but its focus on simplicity has drawn in over 600,000 customers. By sticking to a small set of products, ensuring that pricing is predictable and transparent, and providing ample support and resources to developers, DigitalOcean effectively serves a portion of the market that the market leaders largely ignore.
Cloudflare's core business is protecting and speeding up websites, but it's been able to leverage its edge computing network to offer additional services. It's now possible to build a full-fledged application on Cloudflare, with the company's platform handling hosting, backend processing, and data . The company iterates quickly, adding new products and improving existing ones. While it's not a complete replacement for something like Amazon Web Services, it's become a viable alternative for many use cases.
DigitalOcean grew revenue by 37% in its latest quarter, and Cloudflare posted 54% growth. The pandemic may have helped both companies, but not nearly to the same extent as companies like Zoom. Growth may slow down, especially if the economy sours, but both companies are growing into massive markets and could very well have decades of double-digit growth ahead of them.
Having said that, valuations are still high. Both stocks are on my watchlist, but I won't be buying either one unless this crash continues. I think there's a good chance it will, but no one knows for sure.