Evaluating Rapid Growth Stocks

       

Thematic Thinking Q4 Edition

Gregg Guerin

18th Nov

Key takeaways

  • How watching the Last Dance can help you evaluate a rapid growth stock
  • The drawbacks of using Price to Earnings in isolation
  • Microsoft continue to invest in the Cloud – and for good reason

Evaluating rapid growth stocks (The Four Quadrant Matrix)

Let’s be clear, just because we believe we are not in a bubble DOES NOT mean an investor can’t lose on their investment and investing in rapid growth businesses can be a bumpy ride. See any strong returning stock ever. So, how do you evaluate stocks that are growing at a rapid pace? Here is our 4 quadrant matrix to evaluate rapid growth businesses.

But What about PE? The Failings in Using PE Here

We think that price to earnings is not a good valuation metric for rapid growth businesses, but that doesn’t mean you can’t use traditional fundamentals such as p/s, which we feel is more than effective. However, don’t forget the other two dimensions of price to sales; sales growth and margins. Example: two companies grow revenues of £100 by 10%, and one has 10% margins and the other 50%. One company generates £5 while the other only £1 from the “same growth.” Add a year and you can see how this can start to compound on itself.

Basket Case: Amazon

Over the last 5 years, if you used P/E as your fundamental base, you’d never have bought into Amazon. Clearly it was a good investment, so what else could we have used?

If we look at 2015 as the foundational moment for this company, EPS went from negative to positive (by the way, this may also be happening to Tesla this year). The 5yr average price return was 47.2% and it did this on just 26% sales growth. This was because on a cashflow basis, Amazon produced 62% cumulative annual growth on the above sales number. How? Because their margins moved from 29 to 41%. Why? Largely, because of just three letters: AWS**.

One more example of how even the most professional among us can be wrong. Amazon is in the top 3 or 4 most heavily covered stocks on the planet. The consensus analyst estimates forecast that Amazon would have $1.86 earnings per share in Q2. They were wrong, dead wrong. They earned $10 a share! Interestingly instead of an 18.76 EPS for the year, they are now forecasting 30 EPS. EARNINGS!….for Amazon. 5+ years ago, this was a joke.

We've heard that all before says the experienced vet, “That’s what they said in ‘99.” Well, here are the P/S ratio and weighted sales growth numbers for our thematic ETFs and benchmarks.

Source: Factset
Sales Growth as at 4th September 2020
Price/Sales as of 30th October 2020

* All statistics as at 30th September 2020
** Amazon Web Services is a subsidiary of Amazon providing on-demand cloud computing platforms and APIs
Past performance is not a guarantee of future results.

Here are the fundamentals for the Nasdaq 100 and S&P 500 Indices as of 30th October 2020 vs as of 31 December 1999 along with the respective 10 year U.S. Treasury as discount rate:

Source: Factset

So, where do we go from here – we keep up the hard work of looking at the world around us for themes and then evaluating how those companies are doing. Some themes that pass the smell test for 2020: Internet, Cloud, Cybersecurity, Biotech, Clean Energy, etc.

Now, just one macro stat for just one theme: The global cloud computing market is expected to surge from $371.4 billion in 2020 to $832.1 billion in 2025.3

And, as of the most recent quarterly earnings reports, things are still growing well at the company level. Don’t take it from us, here’s the CFO of the second largest company on the planet*: "Demand for our cloud offerings drove a strong start to the fiscal year with our commercial cloud revenue generating $15.2 billion, up 31% year over year. We continue to invest against the significant opportunity ahead of us to drive long-term growth," says CFO Amy Hood (Oct 27, 2020).

Microsoft is investing in the cloud and we think that’s good advice.

*Based on market cap as at 31st October 2020
3 https://www.marketsandmarkets.com/Market-Reports/cloud-computing-market234.html

References to specific companies should not be construed as a recommendation to buy or sell shares or other financial instruments issued by those companies, and neither should they be assumed profitable.

You should consider the fund’s investment objectives, risks, and charges and expenses carefully before investing. Contact First Trust Global Portfolios at +44 (0)203 195 7121 or visit www.ftglobalportfolios.com to obtain a prospectus or summary prospectus which contains this and other information about the fund. The prospectus or summary prospectus should be read carefully before investing.

"MAJOR DISTURBANCES AND UNUSUAL OCCURANCES" ON US GRID
2000 to 2021

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