Etsy (ETSY 0.34%), a big winner early on in the pandemic, has really disappointed investors in the past couple years. A combination of slowing growth, macro headwinds, and disdain from the investment community for growth tech stocks has lowered enthusiasm for the company.

It's not all bad news, though, especially for long-term investors. There are certainly compelling reasons to add this business to your portfolio.

But if you're looking to buy this top e-commerce stock, you'll regret not understanding the bear case as well.

Etsy's attractive qualities

Right now, it might be one of the best times to buy shares of Etsy. That's because the stock has gotten absolutely crushed, currently sitting 72% below its peak price from Nov. 2021. Even in 2023, when the Nasdaq Composite index has soared 39%, Etsy is down 30% (as of Dec. 14).

This presents investors with an attractive valuation. The stock trades at a forward price-to-earnings ratio of just 17.8. This is cheap for a growth-oriented, profitable company like Etsy with competitive advantages. For comparison's sake, the S&P 500 trades at a forward earnings multiple of 20.4.

In the e-commerce sector, all companies vying for a share of consumer spending must figure out how to compete against the industry behemoth, Amazon. The tech giant has a sprawling logistics footprint and is known for fast and free delivery on millions of items. This doesn't make things easy.

But by focusing on a niche area of the industry like unique, vintage, and handcrafted items, Etsy has built a successful platform. It continues to be the top destination for these kinds of goods.

Another important aspect that makes this stock a solid investment is the network effect. Etsy's 97.3 million active buyers and 8.8 million active sellers, both figures that are up substantially in the last few years, create a favorable situation where the bigger the platform grows, the more valuable it becomes for everyone.

Etsy's scale deters a new entrant from trying to build a rival marketplace from the ground up. It would be a daunting task to attract buyers and sellers to a marketplace where insufficient volume already exists. This protects Etsy's competitive position.

Know the bear case

The arguments for owning Etsy's stock are valid and might prompt some investors to buy the stock. However, you shouldn't ignore the bears' arguments.

The first one deals with declining activity from Etsy's most loyal customers. These habitual buyers, who make purchases on at least six days in a 12-month stretch and spend at least $200 in total, declined for six straight quarters (on a sequential basis) before holding steady at 7.1 million in Q3 2023.

If the business can try to engage previous buyers and encourage them to continue coming back to the site for different shopping occasions, that can be a boon financially. Plus, it could reduce marketing expenses.

But this will be tough given the macro challenges going on. In fact, Etsy just laid off 11% of its workforce due to the unfavorable economic backdrop.

Before investing in a stock, it's also a good idea to think about the management team's performance. To his credit, CEO Josh Silverman has done a wonderful job growing Etsy's marketplace since he took the leadership position in 2017. This is a much larger and more profitable platform.

But I do question the executive team's capital-allocation skills. In Q3 2022, Etsy had to write down the goodwill on its balance sheet by $1 billion, a clear admission that management overpaid for its acquisitions of Depop and Elo7. Both marketplaces were purchased in the summer of 2021 in a strong market environment.

That $1 billion translates to 10% of the company's current market cap, a substantial misstep and opportunity cost for the company. The hope is that the leadership team learns from this costly mistake and seriously improves its capital-allocation decision-making going forward.

These are some of the red flags investors should pay close attention to. While I don't believe they derail the investment thesis for Etsy stock overall, they're still important details that can round out your understanding of the business.