In a market that has seen many tech stocks become 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 firms, IT hardware OEMs or (ha, ha) electric car makers? I think the more attractive names in these sectors generally share a few traits that (when taken together) make them more appealing than growth stocks that only check off some of these boxes. Specifically:
- The companies have clear long-term/secular growth drivers. Think 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 automotive chip content growth, rising cloud capex and growing chip manufacturing capital-intensity for chip developers and equipment makers such as NXP Semiconductors (NXPI) , Marvell Technology (MRVL) and Applied Materials (AMAT) .
- The companies have differentiated, high-margin businesses. Many quality Internet companies have powerful network effects and/or scale advantages that make their businesses hard to disrupt. And many chip developers and equipment makers can lean on IP, engineering expertise and/or architectural lock-in to maintain a leadership position in a given market.
- The companies can be easily valued using a multiple of near-term earnings or free cash flow (FCF). With inflation and the Fed's tightening plans driving Treasury yields higher -- and with them, the amount that long-term cash flows have to be discounted by investors -- it's not hard to see growth stocks sporting moderate earnings/FCF multiples outperforming ones that for now are generating few or no profits. Right now, there are plenty of consumer Internet and chip companies that are poised to see meaningful growth over the next several years and which have forward P/Es below 20.
- The companies are often benefiting from higher prices. Internet marketplaces, payments platforms and ad platforms all tend to get a revenue boost from an environment where inflation is driving goods and services prices higher. Meanwhile, quite a few chip developers and equipment makers are flexing pricing power right now, as they both pass on higher costs and benefit from favorable supply/demand balances.
- The companies' shares have been beaten up on overdone macro and demand fears. Chip stocks have fallen sharply on fears that the industry's current up-cycle is ending...even though companies such as TSMC (TSM) , Qualcomm (QCOM) , ASML (ASML) and KLA (KLAC) reported good numbers in April and signaled demand is expected to remain healthy through year's end, if not longer. And while many consumer Internet firms do face pressures related to reopening activity, the Russia/Ukraine war and/or iOS user-tracking policy changes, they've often been hammered to levels that imply the diminished growth they're seeing due to these headwinds will last forever. The fact that firms such as Roku, Meta Platforms (FB) and PayPal (PYPL) rose post-earnings in spite of 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 firms that arguably check off most of these boxes - for example, Autodesk (ADSK) and Zoom (ZM) . And there are also some differentiated, fast-growing, software firms such as Elastic (ESTC) and Twilio (TWLO) that are producing little or no income/FCF for now, but which have seen their sales and billings multiples fall to historically low levels.
The issue here is that the growth software space still features many companies with elevated valuations -- think firms such as Cloudflare (NET) , Zscaler (ZS) and Bill.com (BILL) -- and the daily movements of both the cheaper and more expensive stocks in the space remain highly correlated. Combine this with how higher yields/Fed tightening might put more pressure on long-duration stocks that can't be valued on near-term profits/FCF, and it's quite possible that many growth software stocks keep underperforming in the short-term.
Admittedly, some of the cheaper, quality companies in the space should probably do well from here over the long run, and a few of them might just become buyout targets (for these reasons, I've taken positions in a couple of cheap growth software stocks). But investors buying them might still need strong stomachs in the near-term.
On the flip side, at a time when...
- Sentiment indicators such as the AAII Investor Sentiment Survey, Investors Intelligence Bull/Bear Ratio and CBOE equity put/call ratio point to exceptionally high levels of investor fear/panic.
- A lot of macro data, earnings reports and executive commentary still point to a fairly healthy economy underpinned by a strong job market and good consumer/corporate balance sheets (even if inflation is high and some consumer spending is shifting from goods to services).
...investor fear might only need to ease a little for consumer Internet and chip companies with long-term growth drivers, differentiated products/services and low or moderate P/Es to rally.