Growth stocks have been all the rage ever since the stock market began its recovery from the financial crisis. However, it was not until the Covid-19 pandemic hit that this dubiously named and loosely defined chunk of the market was catapulted into bubble status.
Personally, rather than calling it a growth stock bubble, I think it is more accurate to call it a second tech bubble. Sure, the stocks involved are a lot more varied in nature than the first tech bubble, also known as the dot-com bubble, but the same spirit is there; in both cases, the stocks involved were part of a newly minted technological revolution that would go on to sweep the world. Since we need to differentiate the two, though, the name “growth stock bubble” can stay.
The growth stock bubble burst at different times for different stocks, but for the most part, the declines began sometime in 2021. Now, most investors do not want to go near these former market darlings with a 10-foot pole, much less their investment dollars. The question on everyone’s minds is, where will growth go from here?
What is a growth stock anyway?
The term “growth stock” has a different definition for each investor depending on the factors they believe to be indicative of growth potential, but in general, a growth stock is one that investors expect to grow business (and thus hopefully share prices) at a much faster rate than the rest of the market.
Some of these stocks, like established tech giant Alphabet (GOOG, Financial)(GOOGL, Financial), Zoom Communications (ZM) and profitable electric vehicle maker Tesla (TSLA, Financial), have proven their abilities already, but others, like DoorDash (DASH, Financial) and Teladoc (TDOC, Financial), are still burning cash. Speculative assets like non-fungible tokens and cryptocurrencies are also considered to be growth opportunities by some, even though making money off of these relies entirely on selling to a greater fool.
The only true growth stocks are the ones with the ability to grow at an accelerated rate for more than just a few years while turning out profits for investors. These are tough to identify in the pre-earnings stage.
For example, a few years back, both Tesla and Teladoc Health were seeing top-line growth alongside double-digit bottom-line declines. Tesla has become profitable, and while its shares are down 50% since all-time highs reached in December 2021, it is not as bad as Teladoc’s continued lack of profitability and 90% share price decline since all-time highs in February 2021.
In this situation, the difference is Tesla’s products will see an accelerating increase in demand over time, while Teladoc’s offerings got a short-lived boost from the Covid-19 pandemic that was always destined to peter out eventually, leading to disappointment for shareholders.
The idea behind Teladoc is great, and there will likely always be a market for digital on-demand doctor's visits, but a great idea does not always translate to a success that investors can grab a slice of. Sometimes this is due to the nature of the product itself, but in other cases, it is because the company is poorly run. For Teladoc, I think the deck was stacked against it due to limited real long-term growth prospects (most major health issues cannot be diagnosed via phone) and the growth stock bubble itself; the company took on massive amounts of debt in 2020 and 2021 in order to prepare for a growth trend that did not continue.
Meanwhile, Zoom is a great idea that became profitable in recent years, but it has seen its bottom line fall back down to earth in the most recent quarter. Without the pandemic "work and learn from home" boost, it's unclear when the stock will recover; its fundamentals are solid, but the pandemic pull-forward could have longer-lasting effects than expected.
One interesting example of a great idea that failed due to poor management and profitability struggles was from the dot-com bubble. Before the likes of Amazon (AMZN, Financial) Fresh, Instacart and Walmart (WMT, Financial) started up their grocery delivery businesses, way back in the late 1990s, there was WebVan, which promised to deliver online-ordered groceries within a 30-minute window.
Customers and investors loved the idea, but after three years of burning cash, the company finally had to call it quits because it just could not turn a profit. The founders attributed part of the failure to not understanding how the grocery business operated.
In short, a growth stock is one that investors have high expectations for in the long run. This means that in addition to excellent companies with solid moats and unique products, unprofitable companies can be growth stocks, as can those that will be bankrupt in a few years. Once the underlying company fails and investors are no longer interested, it is possible for a stock to lose its “growth stock” status.
Trigger events: an investor’s best friend
Growth stock investors are aiming to find the few among the crowd that will go on to become winners. In both the dot-com bubble and the pandemic-driven growth stock bubble, a trigger event occurred that caused enormous amounts of money to flow into capital markets, causing the number of growth stock opportunities to explode. As the new opportunities with compelling stories cropped up left and right, the fear of missing out drew more and more money from investors, causing valuations to swell further.
In the dot-com bubble, the trigger was the rapid adoption of the internet. For the growth stock bubble, it was the Covid-19 pandemic. These events are similar in that they anticipated long-term trends that turned out to not be as fast or all-encompassing as hoped. One could argue the internet was not new by the time 2020 rolled around, but we cannot deny that our world and the way we interact with it are becoming increasingly reliant on technology.
Just like minor trigger events that crystallize value for specific stocks, these two major trigger events crystallized value for the stock market as a whole. However, no market cycle lasts forever. Once the companies and venture capitalists slowed down the rate at which they were pumping money into new ideas, bearishness set in, since those valuations had always relied on a continuous stream of new investments.
Thus, I do not see growth stocks regaining their mojo anytime soon. Where is the trigger event? Where is the money? Without these two things, we are extremely unlikely to see a high-flying rally in stocks that do not inspire faith in their fundamentals just as much as their growth prospects.
The interest rate conundrum
Now we get to the topic of interest rates, which are being blamed for the drop in growth stock valuations so often that one might think the only thing we need to return to a growth stock rally is for the Federal Reserve to just lower the base rate again. Surely if we go back to zero, our favorite growth stocks will all return to their all-time highs, right? Not so fast.
Led by venture capital firms and other institutional investors, the flow of money toward public markets was already beginning to slow before the Fed made a move to hike rates. On an individual level, investors were pulling money out of pandemic favorites like delivery stocks, clean energy stocks, health care stocks and even home exercise stocks like Peloton (PTON) as they realized the growth rates were set to fall off.
While more expensive debt does indeed make it more difficult for companies to borrow money, the Fed does not raise interest rates to cause businesses to fail; it raises them because inflation getting out of control would be much worse for consumers, businesses and the economy as a whole.
Some economists believe the Fed could reverse course and lower interest rates again soon. This viewpoint holds that inflation is being mainly caused by factors completely outside of the Fed’s control (read: supply chain issues). In fact, some believe we could even see deflation soon as supply chain issues resolve only to be met with demand that has been destroyed by inflation and high interest rates.
Ultimately, it is pointless to speculate on something that is dependent on millions of factors that are impossible to take into account. There were also economists calling for deflation in 2021, after which we saw inflation skyrocket to more than 8%.
The important thing is, even if the Fed raises interest rates again, I do not think this will have any material affect on growth stocks in the near term. A deflationary environment is not exactly a recipe for stock market success. The last time the U.S. experienced deflation was in 2009 thanks to the financial crisis.
Time for the leaders to emerge
Just like after the dot-com bubble, I expect the next couple of decades to reveal which revolutionary companies deserve to be called growth stocks. Proving their ability to be profitable and stop burning investors’ cash will be key to this.
Apple (AAPL) was a penny stock before the dot-com bubble burst and wiped out 80% of its value. Microsoft (MSFT, Financial) only lost half of its value at the time, but then again it was more profitable.
For every successful name, there will be some that succeed to a lesser extent, some that fail in their own right and some that were doomed to never develop viable business models in the long run.
So, where will growth go from here? This speculative phase is over, but investors can still find growth opportunities in those companies that are on solid financial footing and offer products for which there will be accelerating and sustainable demand going forward. Good management is also a must; even if an idea is good, incompetent management can kill a business just as fast as low demand.
