Despite recent tapering, rocky stock markets and crises in certain emerging markets, prominent growth stocks such as Facebook (FB), Tesla (TSLA) and Netflix (NFLX) have been surging. Proponents of these stocks cite paradigm shifts and non-traditional valuation metrics to justify ever-increasing fundamental valuation metrics such as price to sales, EV/EBITDA, etc. And short sellers and value investors generally cite astronomical fundamental valuations and are dismissive of the likelihood of paradigm shifts, repeating the mantra that "this time is not, in fact, different". Below I will succinctly describe the bullish and bearish cases for these three growth stocks, and will suggest an alternative that could provide rapid, repeatable growth as well as attractive fundamental valuation - the best of what growth and value investors are looking for.
The bull case for Facebook was well articulated in a recent Wall Street Journal article. The case is that continued growth in the user base and in advertising revenue, combined with improved ability to sell through mobile ads, and evidence of advertising effectiveness on Facebook versus other ad platforms may drive continued growth and further cement Facebook's dominant position in its segment.
The bear case for Facebook is simple: social networking sites can be faddish, there is evidence that users are already shifting use from Facebook to Twitter (TWTR), Vine, and elsewhere, particularly in the teen demographic. Facebook may go the way of Myspace, evidenced by slower user growth and unfavorable user-demographic trends. And investors in the stock are paying over 20x sales and over 40x EV/EBITDA for the privilege.
The bull case on Tesla is that Tesla will go from producing and selling tens of thousands of high-end electric cars in 2014 to producing and selling hundreds of thousands of high-end and mid-range electric cars by 2020. Tesla has overcome hurdles such as making cross-country electric car driving feasible, and seems to have proven that its cars are not unusually likely to catch fire, after positive results from investigations by regulators in the US and Germany. And Tesla is considered a buy-out candidate by any of the major car companies, as its IP could be more easily scaled by a company with a larger balance sheet, manufacturing base, and footprint. And, of course, Elon Musk is considered a brilliant CEO and may create additional value for the company going forward.
The bear case on Tesla is:
1) The company trades at a similar market value to huge car manufacturers despite producing less than 1/10 (or in some cases ~1/100) as many cars.
2) Competitors are ramping up their electric car businesses, potentially pressuring future margins and crowding Tesla's future markets.
3) Competitors have developed their own IP, and have massive R&D budgets, which dwarf Tesla's. They may emerge with superior technology, lower manufacturing costs, and better ability to scale manufacturing to address potential demand.
4) It is unusual for new cars to catch on fire, and several Tesla cars caught fire recently. Despite initial positive reviews by regulators in the US and Germany, more fires could lead to further investigations and potential expensive forced modifications or recalls.
5) Tesla trades at almost 13x sales and its trailing year EBITDA is negative, which is a very high valuation for a manufacturing business, even a rapidly growing one.
The bull case for Netflix is that it continues to grow subscribers to its streaming business. It is the #1 streaming provider, and it is benefiting from a "cord cutting" trend which will drive further adoption of Netflix by consumers going forward. Netflix has proven its ability to create valuable content such as House of Cards and Orange is The New Black, and could become a must-have even for households with cable. So far, Netflix has been able to continue to license content at prices that may not fully reflect its broad user base, which could imply power has shifted from content owners to Netflix. And finally, Netflix is expanding internationally and there is a large growth opportunity abroad.
The bear case for Netflix is based on a variety of factors. First, it is competing with Amazon (AMZN), which is essentially giving away streaming "for free" as an added amenity to its Amazon Prime service. It is hard to compete with Amazon, especially when Amazon's service is free. Amazon Prime is growing rapidly, and could start to cut into Netflix's market share soon.
It doesn't help Netflix that numerous studio executives have publicly complained that Netflix is getting "too much benefit" from their content libraries - this may be indicative of a move by content owners to seek alternative platforms for distribution of the content, and potentially move away from Netflix or charge Netflix substantially more for content.
As Netflix moves into content creation, it incurs risk of failure, which could be both costly and could reduce demand by customers for Netflix's services. House of Cards was extremely successful, but the next series might not be. That is a risk that Netflix shareholders are taking, despite Netflix's historic core competency being delivery of content, not creation of content.
And of course, there is the issue of valuation: Netflix trades at 5.5x sales and an astonishing 80x EV/EBITDA. These metrics imply investors are expecting massive growth, and any of the above cutting into any of the anticipated growth could lead to a far lower share price for Netflix.
Reading through the positives and negatives of each of these investments, it may become evident that there are strong arguments on both sides for each of the above three companies. Yes, they are growing rapidly, and yes they have compelling offerings, but they also face challenges and are priced for perfection.
It is obviously possible to find alternatives to these stocks, as there are thousands of publicly traded companies. In my investment process, I often look for stocks that have some of the growth characteristics of Tesla, Facebook and Netflix (growing rapidly and showing a solid history of growth), while also trading at a large discount to intrinsic value. There are always tradeoffs - in finding rapidly growing, value priced stocks, often they are smaller companies, are listed overseas, or may require specialized industry knowledge to understand. I recently wrote an article about one such stock, and made the effort to explain it in non technical language.
Obviously, certain institutional investors are constrained by geography, size and liquidity. As a smaller investor / investment advisor, I benefit from my ability to pass on investing in battleground growth stocks like Facebook, Tesla and Netflix, while focusing my investment dollars on growth stocks that trade at value prices. And perhaps others may benefit by doing the same.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment adviser capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment adviser. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Additional disclosure: I may buy or sell any stock mentioned with no further notice.