The era of vulnerability begins for next-generation tech stocks
What price growth? That question spilled over into the stock market this week, as the specter of inflation stalked Wall Street and high-growth tech stocks took a beating.
The headlines of a technology reversal, however, masked the very different fortunes of companies in the industry. For Big Tech, this week’s losses barely count as a blip. But investors of the next generation of growth companies face new uncertainty.
Take the case of Palantir, the controversial big data company that went public last September. On Tuesday, its latest financial results showed a resumption of growth and a jump in profitability, at least measured in terms of free cash flow.
Based on the ‘Rule of 40’ measure often applied to cloud software stocks – the rule of thumb that revenue growth rate and profit margin, combined, should exceed 40 – Palantir now ranks among the top 40. Top-rated video conferencing apps, lagging behind Zoom and data warehousing company Snowflake.
Granted, it takes even longer to prove that it has made the transition to the kind of reliable software business model that investors love. And even by the standards of the tech world, his use of stock options seems excessive – including the recent handing over to CEO Alex Karp of a stock and salary package worth nearly $ 1.1 billion.
But this week’s results showed progress. Wall Street’s response? Reducing the company’s shares by 8% when trading opens on Tuesday, prolonging a rout that left them more than 60% below the peak reached earlier this year.
Palantir was not alone. The correction was well underway among the top-rated growth stocks well before the start of this week. Zoom and Snowflake shares are now about 50 percent below their record highs. Cloud software stocks, which had recorded some of the biggest gains, fell across the board recently as the Bessemer Emerging Cloud Index fell 22% from its March high.
Part of this is a much-needed correction after the rally driven by momentum in software stocks. But it also reflects an inexorable financial logic that will make growth stocks one of the biggest victims if financial conditions change. Higher interest rates eat away at the value of profits that lie farther into the future – disproportionately hurting companies whose most profitable years are still a long way off.
There is still plenty of room for further contraction. Snowflake, for example, is still trading at 50 times expected earnings this year, although Zoom’s disproportionate growth during the pandemic has reduced its own earnings multiple to 22 times more manageable.
Tesla, one of the emblems of the current stock market boom, is among those with room for maneuver. Its shares are down about a third from the January high. But Tesla is still worth more than the other four most valuable automakers in the world combined – even though it only accounted for 0.8% of global vehicle sales last year.
The blow to top-rated growth stocks, meanwhile, does not mean an inevitable end to the broader tech-driven equity market rally. A handful of giant tech companies that have led the market up since the start of 2019 are still well positioned to thrive as countries like the US and UK begin to emerge from the pandemic. In the first three days of this week, the combined market value of Apple, Microsoft, Amazon, Alphabet and Facebook fell by around $ 450 billion. But the retirement was less than 6% of their total value.
A surprise surge in growth and earnings in the first quarter of this year demonstrated that having thrived from the digital addiction felt deep in the pandemic, Big Tech is now well positioned to ride the rebound. The strong secular growth trends that have supported them – the shift to digital advertising, the rise of e-commerce, and the overhaul of IT through cloud computing – still have room to work.
This suggests that the next phase of digital growth could produce an even more unbalanced stock market result than the previous one. The big platforms promise reliable double-digit earnings growth at a time when investors are forced to become much more selective.
Things haven’t gone badly this week for Palantir. After the knee-jerk reaction on Tuesday morning, Wall Street took a second look at the company’s results and its shares rebounded 18% at the close, with Zoom and Snowflake also pulling back. In a world where growth is scarce, companies like these should always receive a premium – even if a new period of volatility looms.