A Rate Hike Can Badly Hurt High-Flying Growth Stocks In Tech, Biotech
Growth companies are currently valued very richly not only because they are growth stocks but also because short-term interest rates are almost zero. Waiting for growth companies to reach their potential is inexpensive when it doesn’t incur interest payments, but that can change at any time. There is a real chance that investors will panic about growth stocks when (or before) short-term rates will be raised. Very few investors would believe that a rate hike can hurt stocks like Amazon ( AMZN ), Facebook ( FB ), Tesla ( TSLA ), Netflix ( NFLX ) and LinkedIn ( LNKD ) (or even Alphabet ( GOOG ) (NASDAQ: GOOGL ) – what used to be Google). These are some extraordinary companies. And there are many other companies, especially in the biotech sector, which can have extraordinary growth in the coming years. Very few people doubt that these names are great and will offer exceptional growth in the coming years. I’m no exception – I believe that the mentioned companies, and many other smaller ones, will offer great revenue and income growth over the coming years. But if you look at their valuations Facebook seems to be a bargain, with a respectable trailing P/E of 100. Amazon, Tesla, Netflix and LinkedIn don’t really make any meaningful profits and their valuations are based on their potential alone. And there are many such companies, smaller and less known ones, which are solely valued according to their potential, especially in the biotech sector. Stocks can be quite vulnerable to short-term interest rates because there are very easy ways, for pretty much everyone, to own stock on leverage nowadays without paying much in interest. Other assets are a lot more complicated to own just based on short-term interest rates, as they are quite illiquid, and intermediaries – especially banks since the financial crisis – are not willing to lend at low rates. Therefore it’s not common to see such optimistic valuations anywhere, nowadays, other than in the so-called growth stocks. I am saying “so-called” not because I do not believe they are growth stocks, especially the ones I named, but because the whole idea behind “growth” is subjective and based on popular perception. I don’t remember many people calling Amazon a growth stock 10 years ago. But it was a growth stock even back then, however not popular at all. Just take a look at two charts below, the first one of Amazon, and the second one from the Nasdaq Biotechnology Index ( NBI ). Both Amazon and the biotechnology sector were considered to have growth potential 10 years ago, but their shares were very unpopular. What has happened in the meantime that has made such stocks so popular? Money has become very cheap, and the time value of short-term money has become almost zero, especially if you have access to large sums and you can practically leverage up at almost no cost. This phenomenon was true since 2009, but it truly started to affect the growth sector in 2013. Why 2013? Between 2009 and 2013 there had been too many nasty surprises, especially with the real estate market and then with the European crisis. Probably investors, and particularly hedge funds, started to think that zero interest rates were a safe bet as long as you went for growth stocks. They apparently offered no nasty surprises. And they haven’t offered nasty surprises ever since the crash in year 2000 actually. With hindsight it seems very easy to understand that if you can borrow at practically no cost there is no problem to wait. So, why not bet for companies which offer “certain” growth for at least 5 to 10 years in the future? This way, with some good hedging in place for short-term fluctuations, a hedge fund could do quite well in the longer term. Now the market has become complacent, evaluating growth companies as if short-term interest rates are a sure thing forever. If this changes, it will catch many by surprise. Even the belief that the Fed is certain to raise rates might panic those who are in the so-called growth stocks. But this is to be seen. What is for sure is that very expensive and fashionable growth stocks are not exactly the safe bet they are believed to be. The companies behind the stocks will likely continue to do well, but there is good chance that their current out-of-touch valuations will be a thing of the past, at least for a while. Amazon and Facebook, for example, are truly great companies. They have exceptional management and they have pretty much built monopolies. But they are currently making very little profits to justify their huge valuations. Does anybody know how much they will make in 5 or 10 years? I personally think that Facebook is likely to make $10 billion perhaps in 5 years – for fiscal year 2020. But it’s valued at almost $300 billion now. When will it make $20 billion in a year to justify its current capitalization? In 2025? It is quite possible, though not certain at all. But that is 10 years from now. It is OK to wait if you don’t pay any interest on your money, but if there will be interest to pay things will change. And as any experienced investor knows, when things change course in the stock market it usually happens suddenly and dramatically. The situation is even more serious in the case for Amazon. Amazon is a great company, but one of the reasons it has such extraordinary growth right now is because it doesn’t care about profits. Investors don’t really want to own shares in a company where the management doesn’t care about profits. So they will ask for profits in case the stock will go down – and it won’t be so popular any more. Will Amazon stock be so popular by continuing to offer great service to its customers but almost nothing to its shareholders? Of course this is considered to be a temporary thing, but it is anybody’s guess how much money Amazon will be able to make when it will consider that it has grown enough to start making some real money. It’s also anybody’s guess whether those online merchants whom Amazon will not have killed off by then will not take away its apparently loyal customers. Will Amazon users/customers/members will still stick around in case other online shops will offer better deals? It’s simply anybody’s guess. But in today’s zero short-term interest rates many investors seem not to mind waiting. And this zero short-term rate environment can change soon. And all this waiting has resulted in some too optimistic evaluations for companies which have been able to offer growth for some years now, as if the future is a certainty – which it never is.