In a market that has seen many tech stocks turn cheap by historical standards, I think consumer internet stocks and chip stocks are good hunting grounds for people willing to brave the waters.

Why consumer internet and chip stocks rather than, say, enterprise software vendors, hardware OEMs or (ha ha) electric car makers? I think the most attractive names in these sectors generally share a few traits that (when taken together) make them more attractive than growth stocks that only tick some of these boxes. Specifically:

1. Companies clearly have long-term/secular growth drivers. Think of trends such as online advertising, e-commerce and streaming adoption for consumer internet companies such as Alphabet (GOOGL), Amazon.com (AMZN) and Roku (ROKU), or the growth automotive chip content, increased cloud investment and chip manufacturing capital growth. -intensity for chip developers and equipment manufacturers such as NXP Semiconductors (NXPI), Marvell Technology (MRVL) and Applied Materials (AMAT).
2. Companies have differentiated high-margin activities. Many quality internet companies have powerful network effects and/or scale advantages that make their activities difficult to disrupt. And many chip developers and equipment manufacturers can rely on intellectual property, engineering expertise and/or architectural lock-in to maintain a leadership position in a given market.
3. Companies can be easily valued using a multiple of short-term earnings or free cash flow (FCF). With inflation and the Fed’s tightening plans pushing Treasury yields higher — and with them, the amount that long-term cash flows need to be discounted by investors — it’s not hard to see growth stocks with moderate earnings/FCF multiples outperform those that generate little or no earnings. Currently, many consumer Internet and chip companies are poised for significant growth over the next few years and have forward P/Es below 20.
4. Businesses often benefit from higher prices. Internet marketplaces, payment platforms and advertising platforms all tend to increase their revenues in an environment where inflation drives up the prices of goods and services. Meanwhile, a number of chip developers and equipment manufacturers are adjusting their pricing power as they both pass on higher costs and benefit from a favorable supply/demand balance.
5. Corporate stocks took a beating on exaggerated macro fears and demand. Chip stocks fell sharply on fears that the current industry bull cycle may end…even though companies such as TSMC (TSM), Qualcomm (QCOM), ASML (ASML) and KLA (KLAC) have reported good numbers in April and signaled demand should remain strong until the end of the year, if not longer. And while many consumer internet companies are facing pressure from reopening business, the Russia/Ukraine war, and/or iOS user tracking policy changes, they’ve often been hammered to levels. that involve the reduced growth they are seeing due to these headwinds will last forever. The fact that companies such as Roku, Meta Platforms (FB) and PayPal (PYPL) increased earnings after missing some consensus estimates is arguably a sign that investor expectations for many of these companies are now quite low.

To be fair, there are a few enterprise software vendors that arguably tick most of these boxes – for example, Autodesk (ADSK) and Zoom (ZM). And there are also differentiated and fast-growing ISVs such as Elastic (ESTC) and Twilio (TWLO) that are producing little to no revenue/FCF at the moment, but have seen their sales and billing multiples fall to historically low levels. .

The problem here is that the growth software space still includes many companies with high valuations – think of companies such as Cloudflare (NET), Zscaler (ZS) and Bill.com (BILL) – and the daily movements of cheapest and most expensive stocks in the space remain highly correlated. Combine that with how higher yields/Fed tightening could put more pressure on long-term actions which cannot be assessed on short term earnings/FCF, and it is entirely possible that many growth software stocks will continue to underperform in the short term.

Admittedly, some of the cheaper quality companies in the space should probably do well in the long run, and a few of them might just become takeover targets (for these reasons I’ve taken positions in some cheap stock growth software). But investors buying them might still need strong stomachs in the short term.

On the other hand, at a time when…

1. Sentiment indicators such as AAII Investor Sentiment Survey, Investor Intelligence Bull/Bear Ratio and CBOE put/call ratio indicate exceptionally high levels of fear/panic among investors.
2. Abundant macro data, earnings reports and executive commentary still point to a relatively healthy economy, supported by a strong labor market and good consumer/business balance sheets (even though inflation is high and some consumer spending is picking up). move goods to services).

…investor fear may only need to ease a little for internet and consumer chip companies with long-term growth drivers, differentiated products/services and low to moderate P/Es to recover.

(Marvell, Applied Materials, Amazon.com and Alphabet are holdings in the Member Club Action Alerts PLUS. Want to be alerted before AAP buys or sells these stocks? Learn more now.)