3 growth stocks to buy that could be massive long-term winners
In September, an article on Morgan StanleyThe website was titled “Next Market Rotation Could See Value Stocks Top”. Now some analysts are calling what’s happening in the stock market right now “The Great Spin” – referring to how investors have increasingly sold growth stocks to buy value stocks. And somewhere, investment legend Warren Buffett cringes.
Because in his 1992 letter to Berkshire Hathaway shareholders, Buffett wrote:
Most analysts believe they have to choose between two approaches that are usually seen as opposites: “value” and “growth”. […] We consider it a fuzzy thought […] In our opinion, the two approaches come together at the hip: growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be both negative and positive.
When considering investment options, it would be wise to keep these words from the Oracle of Omaha in mind. And these three growth stocks could be huge long-term winners.
1. Five Below
For the three companies discussed here, I agree that their stocks don’t look like good values right now. But that’s because they spend money prudently to grow their business and earn more later.
Perhaps the clearest example is five below (NASDAQ: FIVE). The Company operates a chain of discount stores catering to teens and tweens. It has grown from 625 locations at the end of 2017 to around 1,200 locations today.
Five Below says opening these stores costs about $300,000 on average. Therefore, in the past four years alone, it has spent around $170 million to expand its store base. It’s a big expense, but consider that these locations have an average payback period of less than a year – Five Below stores generate $450,000 in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) per year, on average.
As he quickly grew his footprint, Five Below’s profits unsurprisingly skyrocketed. In 2017, its full-year diluted earnings per share (EPS) was $1.84. For 2021, it expects to report EPS of at least $4.82, an increase of 162%.
Five Below plans to continue to expand its store count to 2,500 locations. As long as its unit’s economy holds up, the company should continue to grow profits at a blistering pace, bolstering its chances of being a huge stock market winner.
2. Digital Ocean
DigitalOcean (NYSE: DOCN) provides both a technology infrastructure and a technology platform primarily to small and medium-sized businesses. In this case, infrastructure refers to cloud computing and storage while platform refers more to software. Both are huge, fast-growing markets. Management estimates that, combined, these markets will grow at a compound annual rate of 27% through 2025 to nearly $116 billion.
Large, growing markets invite competition, and there is no shortage of players in this space. That’s why I like how DigitalOcean spends a lot on research and development – its biggest operating expense. In the first three quarters of 2021, it spent nearly $80 million on R&D. This may seem small compared to the budgets of large-cap tech companies, but it represents 43% of DigitalOcean’s gross profit. It also increased its R&D spending by 46% year over year over the same period, faster than its revenue growth rate.
To gain market share in a crowded space, companies need to stay ahead of the game, and investing in R&D is one way to do that. That said, DigitalOcean is currently performing poorly when it comes to winning new business. At the end of the third quarter, it had 598,000 customers, compared to 602,000 at the end of the previous quarter. Frankly, if its R&D expenses were really paying off as hoped, it wouldn’t be losing customers.
This problem is real and could cause cautious investors to watch the stock on the sidelines. There is nothing wrong with that. However, be sure to keep monitoring, as chances are that this customer churn issue is a short-term anomaly. Consider that DigitalOcean added about 8,700 customers per quarter on average over the past six quarters, even taking into account the recent drop. For now, at least, the long-term model still suggests the company is developing a product suite that wins new business.
We’ll see if DigitalOcean has returned to Q4 customer growth when it reports on Feb. 24. If so, it could be a sign that the company is still on track to seize a major growth opportunity.
For e-commerce to work well, you need to have a robust delivery system, which Latin America MercadoLibre (NASDAQ: MELI) had limited access when it started. Lacking infrastructure to work with, it gradually built its own.
MercadoLibre launched Mercado Envios, its logistics network, in 2013, and that year it only shipped 10% of items ordered on the e-commerce platform in Brazil. Consider that in 2013 the company sold a total of 83 million items in its marketplace, and not all of them were Brazilian sales.
In the third quarter of 2021 alone, the company sold 260 million items, of which 247 million were shipped through Mercado Envios.
In addition, 80% of MercadoLibre’s sales volume can now be delivered in 48 hours or less. More than half can arrive the same day you order or the next day. These delivery times, made possible by all the distribution points and distribution centers that the company has built over the past few years, are helping to drive the adoption of e-commerce in each market.
However, it was a costly undertaking. In the first three quarters of 2021, MercadoLibre spent $425 million on property, plant and equipment, one of its biggest investments. But that spending paves the way for greater long-term adoption of its platform.
Last 12 months revenue has nearly quadrupled for MercadoLibre over the past three years. Such growth would not have been possible without these investments in infrastructure.
The company’s earnings are currently meager, so they don’t fit the classic definition of a value stock. But back to Buffett’s 1992 letter, in which he also wrote, “The best business to own is one that, over a long period of time, can employ large amounts of additional capital at very high rates of return.” I think MercadoLibre does exactly that, and Mercado Envios is just one example.
Besides, I think Five Below, DigitalOcean and MercadoLibre all have the potential to be the kind of growth stocks we’re looking for. Other investors might view them as overvalued, but today’s investments should pay off tomorrow’s profits.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.