The Dow Jones Industrial Average and the S&P 500 are down over 20% from their highs -- a drawdown that signals both indices are officially in a bear market. But the Nasdaq Composite is in a league of its own. The tech-heavy index is down a painful 33% from its all-time high -- with many individual stocks now at their lowest levels since before the pandemic.
The million-dollar question is whether now is the right time to buy growth stocks or if intensifying selling pressure signals more pain. Let's determine why growth stocks are down big and the best way to identify the best growth stocks to buy now.
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Why are so many growth stocks at multiyear lows?
The reasons why an individual growth stock is down will vary from company to company. But generally speaking, the sell-off is probably due to a blend of valuation concerns, slowing growth, guidance cuts, lower expectations, and a higher cost of capital.
The Nasdaq Composite peaked at 16,212.23 on November 22, 2021. It was around this time that many stocks reached their all-time highs. Ten months ago, investor sentiment was optimistic, interest rates were low, inflation was seen by many as transitory, consumer spending was high, and the economy seemed to have rebounded from the worst of the pandemic. A growing economy and access to inexpensive capital via low interest rates make it easier for unprofitable companies to develop and scale their products and services. Put simply, unprofitable companies and start-ups need time and money. And a good economy paired with low interest rates provides just that.
What's more, multidecade low unemployment and rising home values meant many folks had excess funds to invest, which further drives equity valuations.
Fast forward to today, and the short-term outlook has changed dramatically. U.S. long-term interest rates are now approaching 3% and will likely go much higher as the Federal Reserve continues to raise rates. Average 30-year mortgage interest rates are at 6.3%, which is the highest level in nearly 15 years. The 30-year mortgage interest rate is up a staggering 109% in just one year -- which is a record-high year-over-year increase.
Data by YCharts.
Higher mortgage interest rates make it harder for consumers to justify buying a home, which lowers the demand for housing. According to the National Association of Home Builders, the housing market contributes roughly 15% to 18% of U.S. gross domestic product (GDP). A weakening housing market paired with rising inflation impacts the consumer, which can lower demand.
The housing market may not directly relate to the customer profile of a given company, but there's no denying it has ripple effects throughout the broader economy -- and can indirectly affect a business's performance somewhere down the line.
In addition to the impact on the consumer and the housing market, higher interest rates make it harder for companies to raise money through debt financing. And falling equity valuations make it less favorable to raise cash through equity financing. That puts companies that don't make any money in a lose-lose situation.
Differentiating between unprofitable growth companies and profitable growth companies
The growth companies that have seen their share prices fall the most tend to be unprofitable companies whose previous valuations could only be justified (in the short-term) based on a growing economy with access to cheap capital. So, while it may be tempting to reach into the bargain bin and buy discounted unprofitable growth stocks at multiyear lows, an investor should first make sure the company either has a path to profitability and positive free cash flow -- or enough cash on the balance sheet to outlast a prolonged slowdown in its business.
Just like the dot-com bust of the early 2000s, there's a good chance that some down-beaten growth stocks will emerge as tomorrow's market leaders. But for every Amazon, Alphabet, and Microsoft that emerged from the dot-com bust and produced life-changing wealth, there were dozens of companies that never recovered. In sum, a stock that is down 80% or more from its all-time high isn't automatically a good deal. Instead, it's important to understand that many of these companies are now in survival mode and probably should have never reached their peak valuations in the first place.
No one has a crystal ball. But if a company has a great management team, a compelling product or service offering, and a healthy balance sheet, it could be worth exploring for long-term investors. Conversely, an unprofitable growth company with an unhealthy balance sheet that is quickly running out of cash may not be worth buying, no matter how beaten down it is.
Profitable growth companies offer potentially lower risk than unprofitable growth companies. As an example, let's look at a company like Advanced Micro Devices (AMD -5.44%).
AMD stock is down 59% from its all-time high as economic slowdowns tend to coincide with lower demand for chips. However, AMD is profitable, free cash flow positive, still growing at an impressive rate, and has more cash on its balance sheet than debt. Since AMD isn't dependent on debt or equity financing to run its business and it doesn't pay a dividend, the company is well positioned to outlast a secular slowdown. Investors who are pessimistic about AMD's short-term prospects may be inclined to sell the stock. And while it's true AMD stock could keep falling, nothing has materially changed about the company's long-term investment thesis.
Navigating a brutal bear market
Understanding why growth stocks are down and the differences between unprofitable and profitable companies can provide a roadmap for making smart decisions during a bear market. Buying growth stocks down big off their highs in the hopes the stock will return to its all-time high price is usually a bad idea. A more worthwhile approach is to find companies you believe have what it takes to capture market share in a downturn -- and maybe even gain a leg up on the competition. Investing in these companies can not only lead to compound returns over time but can also help you sleep at night and stress less about market volatility.
In sum, now is an excellent time to buy certain growth stocks, so long as an investor understands the situation could get worse before it gets better.
