It might sound dramatic, but growth stocks in the US are having a torrid time right now. I certainly don’t think these businesses are going to fail, but is growth investing finally going to end its long run of outperformance?
Let’s dig a bit deeper.
Defining growth stocks
It’s best to start with a quick definition of a growth stock. They’re generally companies that are expected to grow significantly in the future. They may not generate much in the way of profit (many are actually loss-making), and they usually operate in new and expanding industries.
Valuing such companies is tricky because most of their profit generation is expected to be in the future. Therefore, the valuation based on a price-to-earnings ratio is normally very high.
US growth stocks are crashing
I started to question if it is the end of the long run of outperformance for growth investing when I was screening for US stocks. I noticed just how many typical growth stocks were down this year, and down by a lot. It’s just not immediately clear because the S&P 500 index is still up an impressive 27% over 12 months.
I’ll name a few examples and their share price returns over one year: Peloton -64%, Zillow -46%, Teladoc -50%, Zoom -54%, Pinterest -42%, Roku -20%, and Docusign -36%.
There’s a bit of a pattern here. Many of these companies benefited because of the lockdowns associated with the pandemic. Zoom, Peloton and Docusign are certainly examples of this. Zillow did decide to shut down its house flipping business after suffering heavy losses. But in general, these businesses performed very well in 2020, and are now crashing.
Then there’s Cathie Wood’s ARK Innovation ETF, a fund that targets long-term growth in capital by investing in “disruptive innovation”. Now, any company that’s disrupting a sector, by its nature, will likely be a growth stock. This highly successful ETF rallied a huge 149% in 2020, but is down 17% over one year as I write.
But why isn’t the S&P 500 down this year when many growth stocks are crashing? This is because the index is dominated by the mega-cap stocks: Apple, Microsoft, Alphabet (Google’s parent company), Amazon, and now Tesla. The share prices of these companies are all up this year. And aside from Tesla, they generate significant profits and cash flows. If these mega stocks started to decline, it would drag the S&P 500 lower.
Is it the end?
There’s no doubt to me that sentiment towards US growth stocks has declined. This is particularly pronounced in the companies that have benefited over the pandemic. I don’t think this will end any time soon, particularly if central banks start to raise interest rates next year.
Having said this, I also don’t think it’s the end of growth investing. But I do think valuations are beginning to matter more now than they perhaps did last year. With this in mind, I won’t be adding any sky-high-valued US stocks to my portfolio unless I have high conviction on the growth rate.
So I’ll be sticking to my investing principles, which is buying and holding quality companies, while aiming to pay a fair price.
Dan Appleby has no position in any of the shares mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK has recommended Alphabet (A shares), Amazon, Apple, DocuSign, Microsoft, Peloton Interactive, Pinterest, Roku, Teladoc Health, and Zoom Video Communications. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.