What's The Deal With Growth Mega-Caps?!

Netflix & Tesla

Growth stocks are tricky. They provide head-spinning rallies on the up, and stomach-churning drops on the down. Investors can be miffed by this conundrum – why have we seen a 53% NFLX and 40% TSLA trailing-24 month drop in prices when the companies haven’t changed? Even when the Nasdaq index fell 13% and the SP500 gained 3% over the same period of time? Well, there’s a graybeard answer for this: value stock prices reflect what the company is, but growth stocks prices reflect what the company is expected to be.

Source: Google Finance 

Few names have reflected this growth-stock rollercoaster better than Netflix and Tesla. Both companies are disruptors in century-old industries. Netflix broke patterns of movie production and broadcasting with their streaming service (and back in the day, with their “rent by mail” DVD service). Similarly, Tesla broke the mold of conventional internal combustion engine (ICE) vehicle manufacturers with a radical combination of battery-based electric motors and a novel high-tech driver’s experience.

This creative disruption gave both companies growth that is very rarely seen in companies of that size. Each of them managed a double whammy of:

• Capturing overwhelming market share by displacing century-old incumbent industries. 2 out of 3 adults in the US are connected to Netflix, and Tesla sells 7 out of every 10 new electric vehicles sold in the US; and,
• Creating and dominating a whole new market at the expense of an old one. Netflix is arguably the originator of the movie streaming business – which first decimated the movie theater industry, and now has overtaken cable as the main delivery mode for video content. Similarly, Tesla is the first – by over a decade – manufacturer to focus solely on plug-in electric vehicles at scale. Since the company’s start in the early 2000’s, the share of EV’s in the total new car market has grown from about 70,000 cars sold in 2015 to about 800,000 in 2022.

Netflix and Tesla’s revenue line grew at an annualized 24.6% and 51.7% compounded annual growth rate (CAGR) between 2015 and 2022, respectively (note: for Tesla, the figure reflects the 12-months to 30 Sep 2022), on the back of an increase in Netflix’s subscriber base to 230.8m from 74.7m and Tesla’s new car sales of 1.3m from about 25k.

But as good as growth is on the up, it can be a destructive “stick in the spokes” when it falls short. Because growth stocks are priced according to what the company is expected to be in 3, 5, or 10 years from now, even small changes in expansion expectations have a compound effect over a longer period. Cutting estimates from a 50% to 25% annualized growth rate means that a revenue line that is 5-years out can drop from 7.6x to only 3.0x today’s number. Still impressive, but less than half prior expectations.

Rapid growth is a challenge for mega-caps – and often proves elusive. Both these names already accumulate overwhelming market shares in the US market and face regulatory or competitive restrictions to grow abroad. Therefore, their expansion depends on both their capacity to continue growing their main business and/or expanding their product portfolio. For example, Netflix has, for a time now, expanded from pure streamlining into original productions and there is a full field ahead with live events (sports?) for the company to explore. Similarly, Tesla has so far focused on high-end personal cars and could look at commercial vehicles and cheaper alternatives – particularly as it competes in emerging markets with low-cost producers from China. But new ventures imply new risks and capital deployment with uncertain results.

Source: Google Finance

Moreso, stocks don’t care about units sold or customers connected – they care about the money made by doing so, and margins erode after the head-start is over. It is not a new phenomenon – practically every new business disruptor has a period of high margins as competitors are slow to react. For example, Tesla operates with a 26.6% gross profit margin compared to 12.1% and 14.8% for Ford and General Motors, respectively. That means that Tesla has about the same gross operating profit as F and GM despite having about half the revenue. But as incumbents and second-wave disruptors begin competing in earnest (Ford and GM as incumbents, and Rivian and Lucid for second-wave disruptors for Tesla), these high margins are challenged as companies are forced into price cuts or increasing operating expenses to defend market share (for example, Netflix’s original productions to compete with pre-existing catalogs like Disney+).

Key Takeaway

All of this to say, the case for high-quality growth stocks can be great, as they will likely, over the long run, provide excess returns for investors. However, as the market adjusts for new growth expectations, be prepared for major bumps in the road along the way. It is important for traders to regularly assess these growth stocks to determine for themselves whether these potholes are worth hitting.

© 2023 Securities are offered by Lime Trading Corp., member FINRA & SIPC, NFA, Lime Advisory Corp is an investment adviser registered with the SEC. and Lime FinTech is a technology business. Collectively known as “Lime Financial” or “Lime” provide various trading, investment advisory services, and technology solutions including web and mobile trading applications, to retail and institutional investors. All investing incurs risk, including but not limited to loss of principal. Further information may be found on our Disclosures Page.

Please read the Options Disclosure Document titled “Characteristics and Risks of Standardized Options” before trading options.

Exchange Traded Funds (ETFs) are subject to market risk, including the loss of principal. The value of any ETF and thus the portfolio that holds an ETF will fluctuate with the value of the underlying securities in the ETF reference basket. ETFs trade with the same brokerage commissions associated with buying and selling equities unless trading occurs in a fee-based account. ETFs often trade for less than their net asset value. Refer to Disclosure Statements | Lime Financial.

Options trading entails significant risk and is not appropriate for all investors. Certain options strategies carry additional risk and investors may lose 100% of funds invested in a short period of time. Investors should consult with a tax advisor as to how taxes may affect the outcome of any options strategy. Options trading privileges are subject to Lime Trading Corp. review and approval. Transaction costs may be significant in multi-leg option strategies, including spreads and straddles, as they involve multiple commission charges.

This material has been prepared for informational purposes only and is NOT intended to provide nor should it be relied on for tax, legal, or accounting advice. Please consult your own tax, legal, and accounting advisors before engaging in any securities transactions as each individual investment(s) may result in diverse/adverse tax implications that will affect the outcome of any investment strategy. No information presented herein should be considered an offer to buy or sell a particular type of security. This is not an offer or solicitation in any jurisdiction where we are not advertised to do business. Other fees, such as regulatory, service, or other fees, may apply. Please visit our Pricing Page for further information. Investments involve risk, past performance does not represent future results. Diversification may help spread risk but does not protect in a down market. You may lose all of your investment. Investors should evaluate their financial situation, investment objectives, and goals before investing. Substantial risks are involved with electronic trading. Day trading involves significant risk and is not suitable for all investors. Please see our Day Trading Risk Disclosure Statement for more detailed information. Trading on margin is not appropriate for every investor. Please see our Margin Disclosure Statement for information on risks. System response may vary due to multiple factors including but not limited to trading volumes, market conditions, system performance, and other factors. Access to electronic services may be limited or unavailable during periods of peak demand, market volatility, systems upgrades, maintenance, or for other reasons.