Era of vulnerability dawns for newer generation tech stocks

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What price growth? That question has reverberated through the stock market this week, as the spectre of inflation has stalked Wall Street and high-growth tech stocks have taken a beating.

The headlines blaring news of a tech reversal, however, have masked the very different fortunes of companies in the sector. For Big Tech, this week’s losses barely count as a blip. But investors in the next generation of growth companies face new uncertainty.

Take the case of Palantir, the controversial big data company that went public last September. On Tuesday, its latest financial results revealed a pick-up in growth and a jump in profitability, at least as measured in terms of free cash flow.

Based on the “rule of 40” measure often applied to cloud software stocks — the rule of thumb that revenue growth rate and profit margin, added together, should top 40 — Palantir now numbers among the most highly rated, trailing only video meetings app Zoom and data warehousing company Snowflake.

True, it still needs more time to prove it has made the transition to the sort of reliable software business model investors love. And even by the standards of the tech world, its use of stock options looks profligate — including recently handing chief executive Alex Karp a stock and pay package worth nearly $1.1bn.

But this week’s results showed headway. Wall Street’s response? To slice 8 per cent off the company’s shares when trading opened on Tuesday, extending a rout that left them more than 60 per cent below the peak hit earlier this year.

Palantir has not been alone. The correction was well under way among the most highly rated growth stocks long before the start of this week. Shares in Zoom and Snowflake are now about 50 per cent below their record highs. Cloud software stocks, which had seen some of the biggest gains, have recently retreated across the board, with the Bessemer emerging cloud index down 22 per cent from its high point in March.

This is partly a much-needed correction after the momentum-driven rally in software shares. But it also reflects an inexorable financial logic that will leave growth stocks among the biggest casualties if financial conditions change. Higher interest rates eat into the value of earnings that lie further in the future — something that disproportionately hurts companies whose most profitable years are still a long way off.

There is still plenty of room for further contraction. Snowflake, for instance, still trades at 50 times this year’s expected revenue, though Zoom’s outsized growth during the pandemic has reduced its own revenue multiple to a more manageable 22 times.

Tesla, one of the emblems of the current stock market boom, is among those with room to fall. Its shares have dropped back about a third from the January peak. But Tesla is still worth more than the world’s next four most valuable car companies combined — even though it accounted for only 0.8 per cent of global vehicle sales last year.

The hit to the most highly valued growth stocks, meanwhile, does not spell an inevitable end to the wider tech-led stock market rally. A handful of giant tech companies that have led the market higher since the start of 2019 are still well-positioned to prosper as countries such as the US and UK start to emerge from the pandemic. In the first three days of this week, before a partial rebound early on Thursday, the combined market value of Apple, Microsoft, Amazon, Alphabet and Facebook fell about $450bn. But the retreat represented less than 6 per cent of their total worth.

A surprise surge in growth and profits in the first quarter of this year demonstrated that, after prospering from the digital dependence felt in the depths of the pandemic, Big Tech is now well-positioned to ride the rebound. Strong secular growth trends that have underpinned them — the shift to digital advertising, the rise of ecommerce and the remaking of IT through cloud computing — still have room to run.

This suggests that the next phase of digital growth may produce an even more lopsided stock market result than the last. The big platforms promise reliable, double-digit earnings growth at a time when investors are being forced to become far more selective.

Not everything this week went badly for Palantir. After the knee-jerk reaction on Tuesday morning, Wall Street took a second look at the company’s results and its shares rebounded 18 per cent by the close, with Zoom and Snowflake also snapping back. In a world where growth is in short supply, companies like these should still command a premium — though a new period of volatility is dawning.

richard.waters@ft.com

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