Your growth stocks better check these 3 boxes during a bear market

This article was originally published on All figures quoted in US dollars unless otherwise stated.

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This article was originally published on All figures quoted in US dollars unless otherwise stated.

Everyone can look smart in a bull market. We saw that in 2020 and 2021 — you could pick about any stock and make money. But now, it seems like every stock is falling, and the sun might never shine again. Don’t let the volatility of the market discourage you. 

The stock market has historically moved in cycles, up and down. This is likely yet another cycle of many. However, bear markets can have real implications for young companies, and growth stocks could face the financial stress of a recession.

No investor wants to buy a stock that falls dramatically and never recovers. If your growth stocks check these three boxes, they’re more likely to live to see another bull market. 

1. Revenue growth

Long-term investors should look to invest in companies that can thrive through good and bad times. Revenue growth is the most straightforward way to measure this. Now, that’s not to say revenue growth can’t slow in a recession — companies rarely grow for years without hiccups.

But a company must show that its business model is durable, that it’s not a fluke or temporary fad. Fitness equipment brand Peloton saw its growth explode upward during the height of COVID-19, but it has since imploded.

Chart showing Peloton's revenue spiking in mid-2020 and then falling.

Data by YCharts.

Whether it’s a lousy business model or mismanagement by leadership (arguably both in Peloton’s case), execution must be consistent, or the business isn’t likely to thrive over time, let alone survive a recession.

2. Positive cash flow

So why do so many growth stocks fall during a bear market? It’s common for young and growing businesses to lose money. Companies can easily raise money when share prices are up in a bull market. They can sell stock at inflated valuations, which prevents investors from seeing their existing shares drop too much in value (dilution).

Suppose a company needs a million dollars and trades at $100 per share. It can raise that money by issuing 10,000 shares of new stock. But say the market crashes, and the stock price falls to $10. Now, the company must issue 100,000 shares to raise the same amount of money. That’s 10 times more shares, so existing shareholders experience greater dilution.

So what’s the solution? A company might be unprofitable for several reasons, and stock-based compensation, a non-cash expense, is one of them. Instead, look for companies generating free cash flow since cash profits go to the balance sheet.

A company burning a lot of cash (negative free cash flow) may need to raise money, and you don’t want that to happen when the share price is in the gutter or forcing the business to take on excessive debt.

3. Healthy balance sheet

Lastly, you want a company with a healthy balance sheet. For growth stocks, this means two things. First, you want to see as little debt as possible. There are times when companies borrow to fund an acquisition, or the business model requires debt like what Opendoor uses to buy housing inventory, but these are the exception and not the rule. 

You also want to see that there’s a healthy cash balance. A company could be so young it’s burning through money, but if it has substantial reserves from a recent IPO, that helps.

For example, cybersecurity company SentinelOne has burned through $105 million over the past year Meanwhile, the stock has fallen from a high of nearly $79 to $24 since its June 2021 IPO.

Chart showing SentinelOne's cash and short-term investments level since 2021, and its free cash flow rising sharply in mid-2021.

Data by YCharts.

You can see how it has almost $1.7 billion in cash. That’s enough money to operate the company for another four years based on its current cash burn rate, assuming the business doesn’t grow or get any closer to turning a profit.

You can’t know what the stock will do in the short term, especially during volatile markets. But you can see SentinelOne’s excellent balance sheet and know it’s doubtful the business is going anywhere, which lets you focus on what drives long-term returns like growth and business execution.

Wrapping up

Growth stocks that show resilience, generate cash profits, and have a strong balance sheet have all the building blocks to become great investments. Focusing on the things that matter instead of the things that don’t (like short-term price action) will put you in a position to do well as an investor. 

This article was originally published on All figures quoted in US dollars unless otherwise stated.

The post Your growth stocks better check these 3 boxes during a bear market appeared first on The Motley Fool Australia.

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Justin Pope has positions in Opendoor Technologies Inc. and SentinelOne, Inc. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has has positions in and recommends Opendoor Technologies Inc. and Peloton Interactive. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips. 

This article was originally published on All figures quoted in US dollars unless otherwise stated.

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