Recession fears have caused the S&P 500 to nosedive into a bear market this year, and many individual growth stocks have lost more than half of their value. For instance, Upstart Holdings (UPST 0.96%) and DigitalOcean Holdings (DOCN 0.06%) have seen their share prices plunge 95% and 78%, respectively, and both stocks hit an all-time low this week. That creates a never-before-seen buying opportunity.
Here's what investors should know about each of these stocks before hitting the buy button.
1. Upstart is helping banks make better lending decisions
Upstart is on a mission to improve the economics of the lending industry. Traditional FICO-based credit models consider a limited number of variables, compromising their ability to measure risk. That often leads banks to make bad lending decisions. Certain creditworthy applicants are denied, while others are charged too much interest to cover the cost of borrowers that will inevitably default.
To fix those problems, Upstart engineered its platform to capture over 1,500 data points per applicant. Those data points train its artificial intelligence (AI) models to identify fraud and predict defaults, which enables its platform to quantify risk more precisely. In fact, Upstart's AI models can separate high-risk borrowers from low-risk borrowers with five times more precision than FICO-based models, according to management.
Unfortunately, the economic environment has been exceptionally hard on Upstart. High inflation and rising interest rates make defaults more likely, causing banks to fund fewer loans. Worse yet, Upstart's AI models have never been tested during a low period in the credit cycle, which makes its platform an especially risky option for lenders right now. Those headwinds led to dismal third-quarter results. Revenue dropped 31% to $157 million, and the company posted a net loss of $56.2 million, down from a profit of $29.1 million in the prior year.
Those metrics look especially bad due to the dramatic deterioration of the economy. Last year, interest rates were low, and consumers were flush with stimulus cash. That led to abnormally low default rates, and it made banks eager to extend credit. As a result, Upstart grew revenue 250% in Q3 2021. But today, rising interest rates and high inflation are financial headwinds for consumers. That has caused default rates to rise, and it has made banks less eager to extend credit, putting pressure on Upstart's business.
Shareholders certainly have a right to be disappointed, but the investment thesis has not changed. Upstart has already demonstrated the superiority of its AI models during a high period in the credit cycle, and if the company can demonstrate similar success in the current economic environment, its share price could skyrocket on the other side of this downturn.
Management puts its total addressable market (TAM) at $1.5 trillion -- a figure that comprises $146 billion for personal loans, $786 billion for auto loans, and $644 billion for small business loans. For perspective, Upstart's loan transaction volume totaled $13.8 billion over the past year, meaning the company has captured less than 1% of its TAM.
With that in mind, shares currently trade at 1.7 times sales, the cheapest valuation since Upstart went public in 2020. That creates a buying opportunity for investors willing to endure extreme volatility.
2. DigitalOcean is democratizing cloud computing for small businesses
Tech giants like Amazon and Microsoft dominate the cloud computing industry, and they offer an exhaustive array of services. But their products are generally designed for large enterprises, as they require robust IT support and extensive technical know-how.
DigitalOcean simplifies cloud computing for small and medium-sized businesses (SMBs). Its platform has an intuitive interface that enables customers to provision infrastructure and platform services in minutes without formal training. DigitalOcean also provides a number of managed services, including databases and an application development platform. In those scenarios, DigitalOcean handles complex tasks like server configuration and maintenance. That frees customers to focus on more relevant things, like building quality software or designing engaging websites.
DigitalOcean reported impressive third-quarter earnings results despite the difficult economic environment. Its net retention rate expanded six percentage points to 118%, meaning the average customer spent 18% more over the past year. In turn, revenue climbed 37% to $152 million, and the company posted a GAAP profit of $0.10 per diluted share, up from a loss of $0.02 per diluted share in the same period last year.
Looking ahead, investors should prepare for a deceleration in growth. Management issued fourth-quarter guidance that fell short of Wall Street's forecast, reflecting economic uncertainty. But the long-term investment thesis remains sound. DigitalOcean has tailored its platform to SMBs, a group that will spend $145 billion on cloud services annually by 2025, according to the IDC. More importantly, given its strong net retention rate, the company is clearly creating value for its customers.
With that in mind, shares currently trade at 6.4 times sales, the cheapest valuation since DigitalOcean went public in 2021. That's why this growth stock is worth buying today.
