You Need Stocks With Growth AND Value

Jan 10, 2022 EducationalInvesting Strategies

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2022 is setting up to be a fabulous year.

Over the last few months, I discussed how small caps and financials were setting up for a fantastic rally.

So far, I haven’t been disappointed.

But now I want to take that a step further and talk about one of the biggest opportunities I see this year: technology and momentum stocks.

You might be thinking I’m a day late and a dollar short on this idea. However, names like Zoom Video Communications (ZM) are up more than 50% in the last six months, creating a value AND growth play.

So why doesn’t that apply to thematic stocks like Peloton (PTON)?

It boils down to a combination of earnings and growth.

I want to explain why some names are ripe for the picking while others should be left for dead, and show you how to differentiate.

Plus, I’ll tell you about a few stocks that I currently have my eye on.

How Higher Interest Rates Impact Our Choices

In one of my recent newsletters, I explained how higher interest rates change an investor’s value calculation. Essentially, higher interest rates raise the opportunity cost of waiting for growth in the future, thereby favoring current earnings.

Going back to the names I mentioned earlier, Zoom Video Communications earned $3.76 per share in the last year and generated $5.43 in free cash flow per share. (Note: Free cash flow is the cash generated by a company’s operations minus capital investments.) This gives ZM a price-to-earnings (P/E) ratio of 46.9x and a price-to-cash-flow ratio of 32.4x.

Peloton has negative earnings and negative free and operating cash flow.

That means all of Peloton’s stock value comes from future earnings, while Zoom is a mixture of current and future growth.

And that’s the sweet spot we’re looking for.

We want quality growth names that currently generate positive earnings or at least positive cash flow.

Paying Attention to Balance Sheets

The next thing we need to look for is heavy debt loads.

As the Federal Reserve raises interest rates, corporate debt becomes more expensive to service. One of the easiest ways to quantify debt burden is to look at what’s known as the interest coverage ratio.

The interest coverage ratio looks at earnings before taxes and interest (sometimes it will also exclude depreciation and amortization) and divides it by the interest payments. (Operating cash flow divided by interest payments also works.)

For negative-cash-flow-generating Peloton, the interest coverage is -26.93x.

Zoom has no debt, which means it has no interest coverage ratio.

Let’s take a look at a few large-cap names:

  • Apple (AAPL) +42.29x
  • Amazon (AMZN) +18.80x
  • Microsoft (MSFT) +33.88x
  • Tesla (TSLA) +8.49x
What this tells us is that higher interest rates will hurt companies with lower coverage ratios like Amazon and Tesla more than it will better-capitalized companies like Apple and Microsoft.

We’re already seeing signs of companies trying to get ahead of the pending rate hikes. Corporate junk bonds, those with poor credit ratings that are forced to pay higher interest rates, saw a massive push in the last few days. These companies, including Ziprecruiter (ZIP), want to keep their interest expenses as low as possible for as long as possible.

Adding in Themes

Now that we’ve looked at the quantitative side of things, let’s consider the qualitative end.

Themes that helped technology and momentum stocks surge last year:

  • Stay-at-home trends
  • Higher consumer demand
  • Scalable enterprises
Zoom fits nicely into these categories. Unless its top-line growth slows down substantially, it should only be a matter of time before momentum turns around again.

Names that don’t fit into this category? Those would be meme stocks like AMC Entertainment (AMC), GameStop (GME), and other businesses that aren’t necessarily broken but drew in more speculators than anything else.

I also want to steer clear of anything with legal issues, such as Nikola Corp. (NKLA). Those carry too much additional risk.

Stocks That Fit the Bill

Bringing this full circle, we can look for opportunities among companies with:

  • Positive cash flow generation and, if possible, positive earnings
  • No or low debt relative to their cash flows
  • Alignment with one or more of the themes from 2021 that we expect to continue into 2022
  • A dramatic drop in share prices in the last six months
That last point is the key because we are looking for stocks where the selling is overdone.

Now, I already mentioned Zoom as a contender.

But other names include Roku (ROKU), which grew revenues 50.54% in the latest quarter YOY, carries an interest coverage ratio of 94.74x, and is down more than 55% in the last six months.

Or look at Stitch Fix (SFIX), which has a three-year average revenue growth rate of 19.66%, no debt, and positive cash flows, and is down almost 70% in the last six months.

Once I collect these names, I add them to my watchlist and wait for the momentum to shift in the other direction, using my signals generated from TradeSmith Finance.

This is crucial. I don’t want to jump the gun and try to pick the bottom. Instead, I need to be patient and wait for the technicals to line up. Otherwise, we could be waiting months before shares turn around. And time is money.

As you think about stocks and sectors that have been hammered in the last few months, which do you think are due for a comeback? And more importantly, why? I look forward to hearing your thoughts.

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