When it comes to investing, there is more than one way to cook an egg.
One such strategy is to invest in growth stocks: companies that have the potential to grow sales, earnings (profits) faster than the broader market.
More specifically, I am talking about disruptive companies that are developing revolutionary technologies, products, or services that have the potential to disrupt industries and the way we live our lives.
Disruptive growth stocks tend to appear pricey as they have a higher than average or even negative price-to-earnings ratio (P/E ratio).
But in hindsight, this price may look cheap in the future, if the company can fulfil their potential and grow their sales and earnings consistently for the long term. Investors who bought in early will profit and enjoy huge returns via capital appreciation.
This is why you must also have a long investment horizon (~10 years) in order to see the growth realised.
However, this strategy is very risky as you are buying the stock at an expensive price based on the expectation of growth. If this growth is not realised, these stocks might crash in price.
With disruptive growth stocks, these companies also face industry-specific risk and government regulation so more research into this area is needed.
Below we offer a couple of tips to help you evaluate disruptive growth stocks and four disruptive growth stocks to look out for.
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock. Information accurate as of 19 Aug 2020.
TL;DR: 4 Disruptive Growth Stocks to Look Out For
|Company||Price to Sales Ratio (P/S)||Stock Price (USD)|
|Square Inc. (SQ)||11.49||$150.37|
|The Trade Desk (TTD)||32.84||$464.01|
How to Value Disruptive Companies
When looking at the disruptive growth stock companies, they often have high growth expectations and high valuations.
This will naturally raise questions about whether these valuations are a realistic match for their expected growth or if their valuations are too high to be investing in.
Here are a few tips for you to evaluate these companies.
1. Don’t Fixate on Earnings-based Metrics
Although traditional earnings-based metrics are important, they are not the be-all and end-all when it comes to disruptive growth stocks.
Some of these companies will have higher than average P/E ratios or even negative ratios, as these companies are not focusing on generating profits at the early stages of growth.
Generally, these companies will not use their free cash flow to pay dividends to its shareholders or buy back their own stocks.
Instead, they will reinvest the money back into research and development (R&D) and/or an aggressive expansion strategy to gain market share to get the company up to speed; usually up to the point where it’s able to enter the marketplace as a serious contender.
In the age of the Unicorn, we are seeing failed initial public offerings from popular companies like Uber, ZTO Express and others, as they have not achieved their desired valuation.
This has brought about increased scrutiny on profitability in this high growth space as typically, the absence of it raises questions about the viability of the company’s business model.
As such, we think that it is important for you as an investor to accurately differentiate companies that are making the choice to forgo profitability in the short-term to invest in a defensible business, compared to companies that cannot achieve profitability due to a flawed business model.
2. Look More at Sales-based Metrics
Alternatively, you should be considering sales-based metrics, like the price-to-sales (P/S) ratio when evaluating disruptive growth stocks.
The P/S ratio is a formula that measures the total value that investors place on the company over the total sales or revenue generated by their business.
Company’s market capitalization (the total number of outstanding stocks multiplied by the current stock price) / Total sales or revenue over the past 12 months
Generally the lower the P/S ratio, the better the investment. Anything from one to two is considered generally decent a value of less than one is generally excellent.
But with all stock valuation multiples, the P/S ratio can be wildly different between industries. Thus it is important for you to compare the P/S ratio of a company to its competitors in the same industry.
The adoption curve is a measure of how the general population adopts a product, service, or technology over time. While adoption curves are a straightforward concept, the ability to create, shape, accelerate, and dominate an adoption curve is what most companies strive for.
Rogers’ theory was that the adoption curve can be divided into five segments to represent the type of adopter and their willingness to adopt new products and technologies. These five segments include the innovators, early adopters, early majority, late majority, and laggards.
By using sales data like total sales and sales growth, you can roughly gauge at which stage a company’s product or service is being adopted. A good rule of thumb is this: if the number of total sales is low but growth is very high, the product or service is at the early stage of adoption.
In contrast, the number of total sales is high but growth is tapering off, the company is on track to achieving mass adoption.
Another thing to consider is the company’s monetisation strategy.
Growth or monetisation is not an either-or choice. You have to look at how monetisation feeds growth as part of a holistic system.
3. Look at a Company’s Debt
Ideally, a disruptive high growth stock should not have too much debt.
To evaluate this you will need to look at a company’s long-term debt-to-equity (D/E) ratio, also referred to as simply the debt ratio is low. But low is relative.
By comparing a company to its competitors in the same industry, you can see if the company you are evaluating has a low or high D/E ratio.
But a high D/E ratio is not the end of the world, it may also be because this particular company is able to get better interest rates for loans which makes more sense for the company to take on more debt to expand. This is why you will also need to look at the financing costs of the debt as well.
Now that you’ve learnt a bit more, about how to evaluate disruptive companies let’s move on to the five disruptive growth stocks to look out for.
1. Upwork Global Inc. (NASDAQ: UPWK)
The COVID-19 outbreak has transformed the way we work.
Early this year, millions of employees were suddenly told to work from home and employers had to learn how to manage all staff members virtually for the first time.
As such, employers views on remote work are changing and it is redefining the corporate environment.
This is where Upwork comes in.
The global gig economy talent management platform offers a win-win solution for both businesses and freelance professionals.
Instead of having to engage a full-time employee, companies can head to Upwork’s marketplace of qualified freelancers and pick the one whose skillsets and costs are a match.
Upwork allows employers to interview, hire and work with freelancers and agencies through the company’s platform.
Companies may then use this platform to reduce overhead costs in the future.
Potentially, Upwork stock is poised for growth as it is simply more cost-effective for companies to hire freelancers for need-based projects.
The company is also growing as according to Upwork’s second-quarter 2020 financial results:
- Revenue grew 19% year-over-year to $87.5 million, exceeding guidance
- Marketplace revenue grew 19% year-over-year to $78.5 million
- Marketplace take rate improved from 12.9% to 13.7% year-over-year.
However, you will not have to pay too much to tap into Upwork’s growth. As of 19 Aug 2020, the stock’s P/S ratio is 5.14. It’s trailing twelve months (TTM) sales per share is $2.91 and its stock price is at US$14.85, down 1% from its IPO price of $15 in 2018.
However, Upwork is still focusing on spending to promote growth which means its gross profit remains negligible.
2. Lemonade Insurance Company (LMND).
Next up with have the Lemonade Insurance Company: a U.S. based property and casualty insurer headquartered in New York City.
The company provides home insurance policies for homes, apartments, co-ops and condos in many American states. It also provides content and liability policies in the Netherlands and Germany.
At first glance, there is little to differentiate how Lemonade and traditional insurers make money, as its revenue is mainly derived from underwriting and the income from investments.
However, what sets Lemonade a part as a disruptor is due to a few things
First, it has an alternative insurance business model based on behavioural economics.
How this model works is that the company takes an initial fixed fee of 25% as profit. The rest of the funds are used to pay for any claims and expenses. If there is any money left over at the end of the year, it goes to a charity of your choice.
This neutralises some of the conflicts of interest between the consumer and the insurer.
The second advantage Lemonade has is that it is fully digital, which reduces operating costs. In addition, the company leverages technology, data and artificial intelligence to underwrite its policies.
User experience on the Lemonade app and on the PC is a breeze to use as you can make process claims on the app itself. The company also automates and promises fast payouts.
Finally, Lemonade is an insurance carrier, which makes it subject to insurance regulation in states and countries it operates in.
This is a very different from how the other InsurTech insurers operate as they engage established insurers to underwrite risk (think PolicyPal).
The first issue is that Lemonade needs to prove that its underwriting capabilities andits advanced technology, is an investment moat that is difficult to replicate. This is so as many of its InsurTech competitors also have similar data-driven capabilities.
As mentioned earlier, Lemonade is a small regulated insurance carrier. In the heavily regulated insurance industry where business revolves around pooling risk, bigger is usually better.
Also, larger more diversified insurers enjoy economies of scale when underwriting risk, in contrast to a smaller less diversified company like Lemonade.
Not to mention that Lemonade is unprofitable so far. The company has not come up with a clear timeline as to when the company will break even.
But, I would think that the risk/reward ratio does not favour long-term investors like us now.
As of 19 Aug 2020, the stock’s P/S ratio is at 36.28 with its stock price trading at US$61.70; more than double of its 2 Jul 2020 IPO price of US$29.
For context, the industry average P/S ratio of other insurers stands at 1.52.
The future is uncertain for Lemonade but it looks like the company can be a good fit to be acquired by a larger insurer.
3. Square Inc. (SQ)
Square, Inc. is an American Financial Technology Fintech company, merchant services aggregator, and mobile payment platform headquartered in San Fransico, California.
The company was founded in 2009 by Jack Dorsey and Jim McKelvey.
Dorsey is also the co-founder of CEO and Twitter while McKelvey is an independent director of the St. Louis Federal Reserve.
The company’s first product was the Square Reader, a mobile credit card reader that allowed merchants to convert their mobile devices into point-of-sale (POS) solutions and accept a whole range of payments.
What Square is doing is digitizing banking for small and medium-sized businesses & payments for consumers. Their company is a disruptor in that sense.
Essentially, the company has built up two successful ecosystems in digital payments for businesses and consumers.
The company’s original seller business enables small and medium-sized businesses to accept card payments with a simple fee structure.
While Its Cash App ecosystem for consumers has quickly expanded beyond a peer-to-peer payments app to offer various services for the underbanked. Both are growing quickly.
On the merchant side, Square aids sellers to start, run, and grow their businesses with a one-stop solution.
The company provides hardware and software to enable sellers to convert their computers and mobile devices into POS solution and also provides services like:
- Payroll services
- Website service called the Square Online Store (think Shopify) that allows sellers to easily create online storefronts and sell online.
On the consumer side, there is the Square Cash App: a rapidly growing mobile payment platform that has quickly expanded beyond its peer-to-peer payment services.
Square has since expanded the app’s functionality to allow users to receive direct deposit payments and Automated Clearing House (electronic) payments, invest in stocks and even trade bitcoin.
Square also offers the Cash Card, a debit card tied to the app that can be used to make purchases offline and online
Its seller business is growing its significant revenue at a slower rate while its Cash App is seeing massive growth.
Square claims that about 64 million businesses use their technology to facilitate credit card payments and track sales (as of mid-2020).
The consumer-focused Cash App is also growing exponentially with 30 million active consumers as of mid-2020, up from 7 million in December 2017. The Company also states that more than 7 million of its consumers are using the Cash App’s debit card.
The company is also looking to connect the two ecosystems with initiatives like linking its merchant side payroll product and paying employees with its Cash App so they could access their funds immediately.
Potentially, Square can create a substantial revenue stream with its seller focused business while maintaining rapid growth with its consumer-focused business in the years to come.
Another factor that will drive Square’s growth? America is moving towards a cashless society, with COVID-19 accelerating the shift.
Logically, we will see cash-only businesses transiting to cashless payments and adopting Square’s unique and convenient solution.
However, you will have to pay a huge premium to tap into Square’s growth. As of 19 Aug 2020, the stock’s P/S ratio is 11.49. It’s trailing twelve months (TTM) sales per share is $13.09 and its stock price is trading close to an all-time high price of US$150.37.
These metrics are high compared to the average financial payments or software stock.
4. The Trade Desk Inc. (NASDAQ: TTD)
Even before the COVID-19 outbreak, The Trade Desk (TTD) was viewed by analysts as an attractive high growth stock.
TTD is an American technology company running a software platform that allows companies to run digital advertising (ad) campaigns across many publisher websites, various ad formats, devices and other channels.
With the COVID-19 outbreak and the resulting quarantine and stay home orders more and more people in the U.S. turn towards connected TV programming like video streaming services.
This environment is a boon for TTD, as the digital advertising market is set to grow as streaming services disrupt traditional television.
But, a lot hinges on TTD’s ability to establish partnerships with publishers to publish TTD’s ads on their platform. As of now, TTD has partnerships with companies like CBS, Fox and the Discovery Channel.
In the short-term, TTD is set to suffer as ad spend around the world has dropped due to the COVID-19 outbreak. However, its long term prospects still look good, as advertisers continue to move towards digital channels.
Interestingly, unlike other disruptive companies, the Trade Desk is actually profitable!
Trade Desk’s net income for the twelve months ending June 30, 2020, was US$0.120B, a 22.38% increase year-over-year.
However, you will have to pay a huge premium to tap into Trade Desk’s growth. As of 19 Aug 2020, the stock’s P/S ratio is 32.84. It’s trailing twelve months (TTM) sales per share is $14.13 and its stock price is at an all-time high of US$464.01.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.