3 Undervalued Growth Stocks I Bought This Month

by: Lyn Alden Schwartzer

Asset prices are elevated throughout the United States, but there are still pockets of value to be found.

At the current time, while I consider myself defensive, I'm happy to take small risks where the risk/reward opportunity is appealing.

I bought these three growth-at-a-reasonable-price stocks in early January to take advantage of the sharp sell-off in technology names.

My recent article on cash and gold may seem bearish, and to some extent it is, so I decided to balance it by showcasing more of the positives I see in terms of investment opportunities.

I bought several stocks in early January, with a focus on names that offer growth at a reasonable price. Growth stocks as a group have outpaced value stocks for a long time, and I already had a large selection of dividend/value stocks. The equity sell-off in Q4 hit growth names the hardest, and provided an opportunity to load up on some solid growth names at reasonable prices.

This article highlights the topic of valuation and malinvestment and then discusses the three biggest buys I made earlier this month.

Easy Money = Questionable Valuations

In the aftermath of the global financial crisis, central banks around the world turned to quantitative easing to restore liquidity, stimulate the economy, and prop up asset prices.

They had already hit rock bottom interest rates, so QE was their way of easing even more into what would otherwise be negative interest rates. This added over $10 trillion to central bank balance sheets worldwide.

Throughout 2018, the Fed has been slowly reducing its balance sheet, and the ECB is the next to follow, but this is just the start and we still have most of that extra liquidity in the global system.

Central Bank Balance Sheet Chart Source: JP Morgan Guide to the Markets 1Q2019

When money is flowing and times are good, investors tend to relax their standards for what constitutes a good investment.

An interesting way to observe this is to look at the percentage of IPOs that are not profitable as they go public. During economic highs, investors seem to have a greater appetite for investing in new companies that have negative earnings:

IPOs with Negative Earnings Chart Source: CNBC

That chart is recent as of Q3 2018, and as you can see we're at major high for unprofitable IPOs that just surpassed the dotcom bubble. Over 80% of new public companies are not profitable, which is up from 30% in 2009.

Investors seem content with growing scale, future promises, and high potential returns, and thus have a willingness to overlook the lack of profits today. This is a sign of widespread bullishness normally associated with economic peaks.

Additionally, despite going public while still unprofitable, these companies have been raising more money while still private than was typical in the past.

2019 is scheduled to be a large IPO year with potentially Uber, Lyft, Slack, Airbnb, Pinterist and others going public. The current government shutdown, however, is delaying IPOs until it is resolved so that may delay or disrupt some of them. Most of those companies aren't profitable yet.

Asset Prices Relative to Income and GDP

The easy money environment has spread into virtually all asset classes. Low bond yields means high bond prices. Low mortgage rates have pushed up home valuations, especially on the coasts. Investors have been forced into stocks for decent returns, which has pushed stock valuations up based on metrics including CAPE, price-to-sales, price-to-book, and market-cap-to-GDP.

Household net worth in the United States has reached a record multiple of disposable income in late 2018:

Net Worth To Income Chart Chart Source: St. Louis Fed

The U.S. ratio of net wroth to disposable income has frequently been under 550%. It hit 610% at the height of the dotcom bubble, 660% at the height of the subprime mortgage bubble, and hit 700% at the height of 2018.

If personal income were to remain relatively steady while the net worth reduces to under 550% like it during the previous two recessions, that would be a 20%+ decline in asset prices.

Another way to visualize this is to compare net worth to GDP. Historically, the total net worth in the U.S. has been approximately 4x GDP or below. In both 2000 and 2007 it crept higher but fell back to 4x afterward. As of late 2018, it was at a record 5.2x of GDP:

Net Worth To GDP Chart

Chart Source: St. Louis Fed

If net worth were to fall back down to 4x, that would also be a 20%+ decline in asset prices.

A mistake I think perma-bears tend to make is that they assume everything always reverts fully to the mean, and then base investment decisions on that expectation. It gets especially problematic when they look back 50+ years and assume averages will always revert even that far back.

My view doesn't rest on that premise. Instead, I think investors should be aware of what happens if asset prices fall to the mean, and also aware of what happens if they simply revert half-way to that mean and thus still stay elevated. That way people people can invest in a way that they are comfortable with, and shouldn't be too surprised during bear markets or recessions; we've been down this path many times even if we don't know the precise magnitude or timing.

Eventually homes get too expensive relative to incomes, companies take on too much debt and start to deleverage, the central bank pulls the carpet from underneath the market by tightening, or some other catalyst acts as gravity for asset prices. This, however, can sometimes take far longer than bears expect before it happens, and may particularly take a while if the Federal Reserve halts their balance sheet reduction.

According to Zacks, the total U.S. stock market capitalization is over $30 trillion and the total U.S. bond market is over $40 trillion. According to Zillow, the value of all U.S. homes is another $30+ trillion. And then there's trillions worth of cash, treasure, cars, and other assets. According to the Federal Reserve as previously shown in charts, total U.S. consumer net worth is in the ballpark of $110 trillion.

These figures get messy because many corporations and international investors own U.S. stocks, real estate, and bonds, and many U.S. investors own foreign stocks and bonds. But it serves the purpose of a back-of-the-envelope calculation.

JP Morgan has nice visual of U.S. net worth that roughly confirms these figures and provides more context.

Consumer Balance Sheet Chart Source: JP Morgan Guide to the Markets 1Q2019

We see homes at about $30 trillion and cash deposits at about $10 trillion. The "pension funds" and "other financial assets" baskets are where stocks and bonds would be, among a smaller set of other investments like private equity.

Not all assets are volatile. Some of them like cash and bonds hold up very well during recessions, while real estate dips more substantially, and stocks tend to be the most volatile.

  • In a scenario where net worth falls by 10% for a half-way mean reversion, and of that total cash and bonds stay flat while real estate goes down by 10%, stocks (SPY) would have to fall by around 20-25%.
  • In a scenario where net worth falls by 20% for a full mean reversion, and of that total cash and bonds stay flat while real estate goes down by 20%, stocks would have to fall by around 40-50%.

Even in the more severe scenario with net worth declining by 20%, total U.S. net worth would still be $88 trillion; well above the 2007 peak of just under $70 trillion.

There are more catastrophic scenarios that can occur; these are just run-of-the-mill recession or economic slowdown outcomes if asset prices deflate anywhere close to their recent historical mean relative to disposable income or GDP.

Additionally, asset prices may partially deflate without ever having a sharp downward movement. Asset prices could stay relatively flat for several years as income, GDP, earnings, and other fundamental metrics catch up. That's basically what happened in 2018, with some volatility along the way.

3 Undervalued Growth Stocks I Bought This Month

For reasons described above, it's important to be cautious when valuing investments in today's environment of high asset prices, high valuations, easy money, and relaxed investing standards.

That being said, I bought a bunch of stocks in January, and these were some of my larger buys.

1) Alphabet

Alphabet (GOOG) has been a very steady grower over the past decade. More recently in the past five years, they've grown revenue by about 18% per year with a very smooth rate.

Chart GOOGL data by YCharts

The vast majority of their revenue comes from digital advertising. The Google search engine, YouTube, Android, Chrome, Chromebooks, Gmail, and various apps serve as portals for billions of users to search for information and receive advertised offers.

The company is then using this advertising revenue to fund a variety of long-term projects including self-driving cars, smart devices, cloud computing, and anti-aging research.

Alphabet's balance sheet is beautiful; the company has $106 billion in cash, $55 billion worth of property and equipment, and just $4 billion in debt. Only about 10% of their shareholder equity consists of goodwill.

The valuation is appealing after falling from its highs; their forward P/E of 23.5 based on analyst consensus estimated 2019 earnings is justified by their growth rate and flawless financial position.

That's not to say the company is without risk. There has been growing complaints about Alphabet's management over the past few years, but that is what appears to be giving investors an opportunity to buy the company for a reasonable price. In other words, it's not priced for perfection.

Some of the high-profile controversies included the firing of an engineer for his memo about gender differences in tech, giving an executive a $90 million settlement despite asking for his resignation after finding evidence of severe sexual harassment, dropping U.S. defense contracts while going back and forth on whether to build a censored search engine in China, weathering growing concerns over data privacy, and more.

So far, none of these seem to stop people from using all of Alphabet's platforms. Targeted regulation and special digital taxes may eventually impact Google's advertising business, but their other projects represent significant upside potential to counter that risk.

Google grew revenue and net income through the financial crisis. I like the company for the sake of risk diversification; the company has limited exposure to economic slowdowns in exchange for elevated risks from regulation.

2) Micron

Micron (MU) is one of the top three global suppliers of DRAM and one of the top six global suppliers of NAND.

While these products are highly cyclical, their long-term past and future growth trends are enormous. Smart vehicles, smart devices, hyper-scale cloud computing, widespread applications of machine learning, and other long-term trends all require large amounts of memory.

Chart MU data by YCharts

Micron has more cash than debt on their books, has a lower cost of production than during previous memory cycle troughs, and is trading at a forward P/E of under 5.

I covered Micron in detail in late December in this article, which I wrote during their recent price bottom. It's up over 15% since then but it's still very appealing at current prices in my opinion for investors that have a high tolerance for volatility and that appropriately manage their position sizes.

3) Alibaba

Alibaba (BABA) is one of the biggest e-commerce companies in the world, with over 600 million customers. They also have a growing cloud business, digital media business, fintech, and a variety of other businesses within their broad ecosystem.

Concerns over the U.S./China trade war, along with slowing economic growth in China and China's corporate debt bubble, have pushed Chinese stocks to very low valuations. The MSCI China index has an estimated forward P/E of about 10 and a current P/B of about 1.5. China's market cap to GDP is sitting near record lows.

Alibaba with its higher growth and higher valuation was not spared from the sell-off, and lost about a third of its value in 2018 before seemingly stabilizing.

Chart BABA data by YCharts

The company has had 40%+ annual revenue growth over the past five years, but trades at a forward P/E of about 30.

The company has $27 billion in cash with $20 billion of debt, converted from local currency. They do have significant goodwill from their various acquisitions, but overall their balance sheet is moderately good.

Rather than buying Alibaba directly this month, I actually bought the KraneShares CSI China Internet ETF (KWEB). Its three largest positions are Alibaba, Tencent, and Baidu, and Alibaba is my preferred choice.

I like this ETF's broad exposure to the Chinese internet and e-commerce sector, which doesn't really have much direct exposure to China's large corporate debt. It gives investors broad participation without much single-company risk.

Final Thoughts

After partially recovering from the Q4 sell-off, U.S. stocks and assets in general are back up at high valuations. It's an environment that suggests caution over the next couple years.

That being said, if we get enough good news this year, 2019 could still hit record equity market levels, so I don't try to predict what markets or stock prices will do in any given calendar year. If the government shutdown comes to a resolution shortly, the U.S. and China form a trade agreement, and the Federal Reserve keeps interest rates flat and maybe even cuts back on balance sheet tightening, asset prices could very well stay high.

Generally speaking, I find good opportunist to exist in somewhat defensive stocks. For example, I have a list of top 7 long-term stocks to buy and a 15+ high dividend stock sample portfolio.

However, due to the current downcycle in semiconductors, and concerns over technology regulation in general, many good tech names are down to reasonable valuations as well.

I'm happy to buy Alphabet, Micron, and Chinese tech stocks as part of a diversified portfolio. All of these names are relatively out-of-favor at the moment.

They could indeed go down during the next downward market movement, and I have no specific 1-year or 2-year target prices. Over the next 5 years their current valuations, strong balance sheets, and anticipated growth rates put the odds in their favor.

Disclosure: I am/we are long GOOGL, KWEB, MU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.