Why Growth Stocks Can Leave Traders Extremely Vulnerable

By: Wayne Duggan

The late-year market sell-off caught a lot of traders off-guard, but some stocks were certainly hit harder than others. One of the hardest hit groups of stocks has been growth stocks, which have been market leaders throughout most of the 10-year bull market. Here’s a look at why growth stocks are typically some of the biggest victims when investors get jittery.

Identifying Growth Stocks

When traders refer to “growth stocks,” they are typically referring specifically to revenue growth. Revenue is simply a measure of how many sales or how much business a company is doing and is often not a good indicator of a business’ efficiency or profitability. For example, Amazon ($AMZN) was criticized for years for generating little or no profits, despite growing into one of the largest and most successful companies and stocks on Wall Street.

Growth stocks typically report revenue growth at or above 20 percent, but revenue growth of 40 percent or higher is not unusual. These growth stocks typically trade at a valuation premium to the rest of the market because, like Amazon, investors are willing to pay high prices for shares because they see tremendous long-term potential in growth stocks.

Why Growth Stocks Are Targeted

It’s no surprise that growth stocks are usually first on the chopping block when investors get jittery about the economy. When the market hits a bump in the road, investors tend to rotate out of growth stocks and into value stocks because value stocks are considered to have downside protection.

Look at it this way: the price-to-earnings ratio of the S&P 500 hasn’t meaningfully dropped below 15 in the past 30 years. Even during the financial crisis in 2008, the market has assigned a base level of value to a company’s ability to generate earnings. In other words, a stock that is meaningfully profitable and reasonably valued in the market has a theoretical limit to how low its share price can drop. A growth stock with little or no profitability and an extremely high valuation has no downside protection.

To take things one step further, many growth stocks are saddled with high debt loads. That means they rely on borrowing money — rather than organic cash flow — to cover the costs of their rapid expansion. If credit markets dry up, these stocks can be exposed to bankruptcy if they are unable to gain access to credit. For example, Tesla ($TSLA) CEO Elon Musk recently said the company was within weeks of failure earlier in 2018 because of the costs associated with ramping up Model 3 production.

Growth Stocks to Watch

If the year-end volatility morphs into something more concerning in the closing weeks of 2018, the worst may be yet to come for popular growth stocks. However, if the market bounces back, these growth stocks could be excellent long-term buying opportunities.

Here are seven popular growth stocks that have taken a beating in the past three months:

  • Square ($SQ) down 18.5 percent.
  • Facebook ($FB) down 21.1 percent.
  • Netflix ($NFLX) down 21.6 percent.
  • Canopy Growth Corp ($CGC) down 29.5 percent.
  • Roku ($ROKU) down 32.6 percent.
  • JD.com ($JD) down 33.6 percent.
  • Nvidia ($NVDA) down 43.5 percent.

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Disclosure: the author has no position in the stocks mentioned.

Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services provided by any of the above service providers and any service used to execute any trading strategies are solely based on the independent analysis of the user.

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