Shares in two of the FTSE 250’s hottest growth stocks, HomeServe(LSE: HSV) and Metro Bank(LSE: MTRO), have plunged over the past month, at a far faster rate than the rest of the index as investors have jumped ship.
Shareholders of have been left wanting as HomeServe has underperformed the FTSE 250 by 5% since the beginning of the month, and Metro has skidded 32% since the beginning of August.
And while I think these companies still have bright prospects, there are three reasons why I believe there could be further declines on the cards before confidence returns.
Sell, sell, sell
First off, shares in both of these companies still command a premium valuation even after their recent performance. Metro is trading at a forward P/E of 41 while investors will pay 25 times earnings for HomeServe today.
If we factor in growth, these valuations look a little more acceptable. Indeed, Metro is expected to chalk up earnings per share (EPS) growth of 265% this year, and 90% for 2019. While HomeServe is targeting EPS growth of 22% for fiscal 2018.
However, in this risk-off market, investors are not prepared to wait around and see what might happen in the future. As volatility continues, I wouldn’t be surprised if both of these companies fell to more subdued valuations.
Buy, buy, buy?
As well as premium valuations, both of these businesses are aggressively expanding, which has sparked some concerns among investors. Metro asked shareholders for more than £300m through a new share placing earlier this year to fund growth, igniting speculation that the firm is growing too fast for its own good.
Meanwhile HomeServe, which has been growing for years using the same buy-and-build model, (and indeed today announced the completion of another acquisition) has seen its debt explode in recent years.
According to my numbers, total debt as a percentage of tangible assets has risen from 35% to 52% over the past five years. Investors have been willing to support this strategy as the market has trotted higher, but now that volatility has returned, I reckon shareholders are taking a more skeptical approach to this strategy.
Finally, I think investors will continue to avoid these companies because they lack income.
Defensive income stocks tend to outperform during market crashes as dividends cushion the blow from falling stock prices. Unfortunately, when it comes to income, Metro doesn’t offer a dividend (and analysts don’t expect one anytime soon), and HomeServe only offers a token yield of 2.3%.
As the home services company’s payout is only covered 1.8 times by EPS, it doesn’t look as if there’s any further room for growth here either.
The bottom line
Overall, it looks to me as if these two FTSE 250 growth stocks could fall further as volatility continues. But if they meet City growth expectations, I think this decline might be short-lived.
In other words, now could be the perfect time for Foolish investors with a long term outlook to get involved with these FTSE 250 growth champions.
There are a number of small-cap stocks that could be worth buying right now, and our investing analysts have written a FREE guide called "1 Top Small-Cap Stock From The Motley Fool".
The company in question may have flown under your investment radar until now, but could help you to build a great income from your investments and retire early, pay off the mortgage, or simply enjoy a more abundant lifestyle. Click here to find out all about it — it's completely free to do so.
Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Homeserve. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.