- Unprofitable growth stocks still face significant headwinds as they need to raise cash at depressed valuations, according to Goldman Sachs.
- The bank said even after 70%-plus declines in certain growth stocks, there could still be further pain ahead.
- Cathie Wood's Ark Invest made a name for itself by investing in innovative companies, most of which are not yet profitable.
Unprofitable growth stocks that staged a remarkable boom and bust cycle after the COVID-19 pandemic could still face significant headwinds before recovering, according to a Monday note from Goldman Sachs.
The bank said that while growth stock valuations no longer appear expensive, they're also not yet depressed, which is a big possibility considering prior market action during the unwind of the dot-com bubble and Great Financial Crisis.
Goldman's research could raise eyebrows for investors that hold ETFs managed by Cathie Wood's Ark Invest, as the firm made a name for itself by owning a concentrated portfolio of innovative tech stocks, most of which are not yet profitable.
The challenges facing speculative growth stocks include a shifting investor mentality of buying safety stocks and reducing speculative holdings amid a broader bear market decline and increased worries of an economic recession.
But other challenges speak more to the underlying operations of unprofitable companies and whether they have enough cash to keep the lights on, according to Goldman, which highlighted the rising cost of capital that is necessary to fund the business.
"Currently profitable growth stocks may be able to finance continuing operations through retained cash flow. However, some unprofitable growth companies will need to raise capital externally in order to remain solvent," Goldman explained.
Unprofitable growth stocks have three options as Goldman sees it:
1. Raise cash by selling stock as a steep discount to prior valuations;
2. Raise cash by issuing debt during a time when high yield credit markets have slowed considerably;
3. Or pursue a merger with another company amid a deteriorating outlook for the broader economy.
"The rising cost of capital, tightening financial conditions, and growing recession risk will limit the potential valuation upside for unprofitable growth stocks," Goldman said.
One recent example of this is the case of Zymergen, a biotechnology stock owned by Ark Invest's Genomic Revolution ETF. The unprofitable company has plummeted 96% from its April 2021 record high, and that's after the company agreed to merge with Ginkgo Bioworks on Monday.
And while investors might be tempted to buy stocks that have seen their valuation fall by upwards of 90%, Goldman points out that there's still room for valuations to fall further based on prior unwinds in speculative stocks.
"The median high-growth stock has de-rated from a peak LTM EV/sales [multiple] of 14x in late 2021 to 4x today, slightly below its long-term median. However, growth stock valuations previously troughed at 2x EV/sales post-Tech Bubble and 2x EV/sales in the Great Financial Crisis," Goldman said.
That means some unprofitable growth stocks that have already seen their stock prices decimated by rising interest rates and concerns of an economic slowdown could fall upwards of another 50% from current levels, based on historical market action.
"Despite the valuation reset, challenges for unprofitable growth stocks remain," Goldman concluded.