Growth stocks haven’t been terrific performers of late. These companies tend to have the most long-term potential, which leads to far loftier valuations compared to already mature industry titans.
As such, when market uncertainty creeps in, volatility surrounding shares trading at a premium is usually far higher.
But with the macroeconomic environment starting to become clearer and the British economy beginning to settle, investor confidence is on the rise. As such, investors are beginning to take a second look at growth-oriented companies for potential bargains in the aftermath.
After all, buying a high-quality business at a fantastic price is a proven recipe to make money, especially when recovery tailwinds are blowing.
The question is, how can investors find these wealth-changing opportunities?
Growth vs value
A growth stock isn’t difficult to spot. These are companies that are typically younger, offering a novel product or service that is in rapidly rising demand. With most capital being allocated towards internal investments and marketing, it’s not uncommon for these businesses to be unprofitable. But this added level of risk is often offset by high double, or sometimes even triple levels of revenue growth.
Where things become trickier is creating value. There are plenty of businesses capable of growing sales. But few actually find a path to profitability before the money eventually runs out. That’s why so many unprofitable high-growth tech firms are now struggling to stay afloat, leading to massive job cuts across the sector.
But not every business is in this basket. There are a few generating sufficient free cash flow to maintain and expand operations.
One example from my portfolio is MongoDB. The cloud database platform is still hiring in 2023 despite most of its competitors hitting the pause button. How? Because the cash-generative nature of its products makes the group far less dependent on external financing to stay alive. That gives management far more flexibility as well as the opportunity to steal market share.
What to look for
As I just highlighted, free cash flow is one of the first things I look for when evaluating the financials of a growth enterprise. A firm capable of generating more money than it spends accelerates the growth story and the journey along the path to profitability.
However, it’s not the only important trait. Beyond achieving top-line growth, I like to see high levels of liquidity on the balance sheet. These are assets that can be quickly converted into cash to meet short-term obligations. It also provides an emergency fund for corporations undergoing temporary market disruptions, whether it be internally or externally.
Debt is also another factor to consider. It’s less common to see among unprofitable enterprises, but loans can be problematic when close to maturity. A company already being squeezed by unfavourable market conditions could land itself in even more hot water if a bunch of outstanding debts become due.
And while management teams often have the option to refinance, doing so today would likely be at a much higher interest rate versus a few years ago.
Obviously, these aren’t the only factors that determine a good or bad growth investment. And there are countless qualitative characteristics to consider, such as competitive advantages. But filtering out the stocks that financially fall short can quickly eliminate subpar investments from consideration.
