Why Twilio, MongoDB, and Datadog Rallied for the Second Day in a Row

What happened

Shares of high-growth software stocks Twilio (TWLO -1.47%), MongoDB (MDB -2.55%), and Datadog (DDOG -3.88%) were rallying this morning for the second day in a row, up 4.3%, 2.5%, and 6.6%, respectively, as of 11:39 AM EDT. 

It's not hard to figure out why: This morning's Consumer Price Index (CPI) report from November came in lighter than expected -- making it the second month in a row that the CPI has surprised to the downside.

High-growth but unprofitable tech stocks have proven to be highly sensitive to inflation and interest rates, and yesterday and today's surges were no different. But is it too early to declare an all-clear to buy these types of beaten-down growth stocks? 

So what

For the month of November, the CPI index increased only 0.1% month over month and 7.1% year over year. Core inflation, which strips out volatile food and energy prices, increased 0.2% month over month and 6% year over year. The monthly increases were below the 0.3% expected on both counts.

What's especially encouraging was that the lower inflation was fairly broad-based, and shelter inflation, a lagging indicator, was up 0.6%, skewing results higher. However, the shelter statistic lags by six to 12 months; meanwhile, most real-time data shows that shelter prices are actually turning negative. Therefore, the CPI trend may actually be lower than even these good numbers indicate.

This was certainly welcome news, after this year's post-pandemic inflation surge increased long-term interest rates while also forcing the Federal Reserve to raise the federal funds rate incredibly rapidly.

Rapidly rising inflation and interest rates are usually bad for all stocks, but especially for unprofitable stocks that don't pay out dividends to shareholders. This is for a number of reasons; rising rates increase the attractiveness of short-term bonds over stocks, giving stocks competition for investment dollars. Rising interest rates also slow the economy by making borrowing more expensive. Meanwhile, since the intrinsic value of any stock is the present value of all future cash flows discounted back to the present, the further out a company's profits, the less they are worth in today's dollars. Therefore, if a stock is printing losses today, with the bulk of its value in cash flows many years out, its valuation will suffer disproportionately in a higher-rate environment.

This is why the last two months' lower inflation was such welcome news for unprofitable growth tech stocks like Twilio, MongoDB, and Datadog.

The surge follows yesterday's big move higher, which was perhaps triggered by an anticipation of the lower CPI print today, as well as the high-profile acquisition of another software-as-a-service peer by a private equity firm.

Now what

When the entire investing community is focused on macroeconomic factors, it can be easy for company-specific factors to get lost. Investors shouldn't necessarily neglect profitless growth stocks; however, even though inflation is moderating, there is still a high probability that interest rates will wind up settling significantly higher than during the pandemic, when long-term bond rates tracked below 2%.

That means investors need to be more discerning about high-growth stocks. Going forward, it will be important to figure out exactly how much a company can realistically grow revenue over the next decade and what a company's terminal profit margins (including stock-based compensation) will be.

For instance, Datadog was able to actually produce operating profits (according to GAAP or generally accepted accounting principles) earlier this year, before last quarter's spending dipped its year-to-date operating income into the red for the year. Still, Datadog has been able to maintain very healthy growth rates this year even as many software companies are reporting a slowdown, and it operates near breakeven.

So one can assume Datadog will one day be quite profitable, whereas Twilio, which posted an operating loss of nearly half a billion dollars last quarter alone, is not nearly as likely to ever be materially profitable.

Today's lower inflation report is certainly good news, and certainly could be a sign that growth stocks will regain some of their luster after this year's brutal declines. However, investors should not expect a reversion to pandemic-era growth rates and rock-bottom interest rates. That means investors need to be more discerning among specific companies, as the bottom line for these high-growth companies will continue to be more of a focus than it was in the recent past.