A reversal in long-term rates and inflation concerns allowed high-growth stocks to bounce big this week.
What happened
Shares of enterprise software companies Datadog ( DDOG 6.84%), MongoDB ( MDB 4.29%), and Twilio ( TWLO 1.75%) rallied this week, up 25.5%, 21.4%, and 18% on the week through Friday, respectively.
There wasn’t much in the way of company-specific news this week. However, each is a very high-growth stock, with much of its earnings far out into the future. Thus, they are extremely sensitive to long-term interest rates. After six months of long-term yields doing nothing but seemingly going straight up, yields backed off their decade-long highs in a big way this week. High-growth stocks, which began falling last November before the indices, rallied in a big way in response. So what
The enterprise software sector is, all things being equal, a very attractive sector. These tools help businesses function and become more productive, and they tend to be “sticky” products. After all, it’s a pain for companies to switch and retrain their entire workforce on a new software system, and you aren’t going to stop using software if the economy goes into a downturn. Meanwhile, recurring subscription revenue is quite attractive, especially in lean times or a recession.
Still, many enterprise software stocks trade at very high multiples of earnings. In the case of these three companies, there are still no earnings to speak of, although Datadog is slightly profitable. Both Datadog and MongoDB trade at very high multiples of sales, despite being well off their highs. While Twilio trades at a more reasonable price-to-sales ratio of 5.6, it is also generating massive losses on its bottom line that the other two companies aren’t. MDB PS Ratio data by YCharts Since the bulk of these companies’ value is far out into the future, the discount rate investors use to discount those future earnings in present-value terms matters a lot. That discount rate is usually based on a premium added onto the long-term risk-free rate, for which many investors use the 10-year Treasury bond yield as a proxy.
After the Federal Reserve hiked the Federal Funds Rate by 75 basis points in the week before last, long-term rates have been falling in anticipation of an economic slowdown. Since reaching a high around 3.48% on June 14, the 10-year yield finished this week at 3.12%. That’s a fairly big reversal in a short amount of time, and has proved to be a boon for high-growth software stocks.
Moreover, the June University of Michigan Consumer survey on inflation expectations over the next five years was revised down to 3.1% on Friday, down from the 3.3% reported earlier in the month. That perhaps signaled that inflation expectations are not as entrenched as some thought earlier this month, so the economy may not require significantly higher interest rates to tame inflation. Now what
Even though these stocks saw a nice bounce this week, and each business is growing nicely, these stocks are still pretty expensive. While high-priced growth stocks did phenomenally well over the past few years, it’s unclear if interest rates will return to the extreme low levels seen during the pandemic.
Furthermore, these companies have a lot of growth baked into their share prices already, and it becomes harder to grow the bigger you get. All three appear to have bright futures, but a high valuation leaves relatively little margin for error. So while these companies could rally back to all-time highs, I still wouldn’t characterize them as “cheap,” even after their sell-offs this year.
Datadog and MongoDB appear to be especially disruptive products with large addressable markets, so they are on my watchlist. However, they are only appropriate for younger investors in high-growth stocks who can tolerate big near-term drawdowns, not older investors near retirement. Should you invest $1,000 in Datadog, Inc. right now?
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Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has positions in and recommends Datadog, MongoDB, and Twilio. The Motley Fool […]
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