These 2 Stocks Carry a Lot of Risk, but Their Upside Is Huge

As an investor, I like to maintain a portfolio of world-class, blue-chip companies that reward me with dividends for holding their shares and allow me to sleep soundly at night, knowing that I own a small piece of a great business. But in a well-rounded portfolio, there is also room to add a smaller allocation of some higher-risk stocks that have the potential to supercharge your returns over time if they pan out.

Taking on higher risk typically entails the potential for higher reward as investors need to be properly compensated for the risk they’re taking. Risk can come in many forms — perhaps the company has a worrisome debt load. Maybe its core business is in decline, or the stock trades at a nosebleed multiple.

Here are two high-risk, high-reward stocks that have the potential to provide outsize returns to risk-tolerant investors as part of a well-rounded portfolio.

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1. Carvana

Carvana (CVNA: 40.07%) is arguably the ultimate high-risk, high-reward stock. Shares of the internet-native car dealer are down 86% year to date as rising interest rates and fears of a recession have curbed the market’s appetite for “story stocks” that aren’t making a profit. Furthermore, many observers fear that it is living on borrowed time because it won’t be able to service its high debt load.

Sounds like a lot of risk, right? It is. But here’s why the reward is potentially massive as well — Carvana is exhibiting scorching revenue and unit volume growth while establishing a strong foothold in a $1 trillion end market.

Buying a used car is one of the average consumer’s least-favorite experiences, probably right up there with getting a root canal. The legacy used car business is a massive market that is ripe for disruption. Carvana’s platform, which enables users to buy and sell vehicles online, certainly shakes it up.

The platform is easy to use (in my experience) and convenient as Carvana sends one of its trucks to pick up the vehicle from your house (if you are the seller) and can deliver it right to your driveway (if you are the buyer) . Users don’t have to go to a used car lot or haggle with a salesperson. Furthermore, with over 70,000 vehicles available on its platform, Carvana offers a far superior selection than a buyer would get by heading down to their local dealership.

The company has already grown into the second-largest used-car dealer in the United States in just eight years of existence, so clearly this model is resonating with consumers. Further to this point, Carvana has been growing both revenue and unit volume at a torrid pace over the last few years. Carvana’s revenue was just under $2 billion in 2018 but increased to over $12.8 billion in 2021. The company sold 94,000 cars in 2018 and 425,000 in 2021.

This revenue and unit growth is great, but bears are correct in saying that it means nothing if the company can’t eventually turn a profit. But the good thing is that Carvana’s management team isn’t burying its head in the sand — they are well aware of this and are working to slow down the company’s cash burn and prioritize becoming cash-flow positive.

Carvana plans to cut SG&A expenses, lower capital expenditures, and improve unit economics on each vehicle bought and sold. The company has made steady progress on gross profit per unit over the last few years, from just $206 in 2015 to $4,537 in 2021.

Given what Carvana has accomplished over the last few years, there is reason to believe that it can figure it out and execute on this plan, at which point the company would be able to not only survive but thrive. This is as high-risk, high-reward as it gets, and I have allocated a small part of my overall portfolio to it, which is no more than I am willing to lose.

2. Dutch Bros

My second high-risk, high-reward stock is: Dutch Bros (BROS: 4.25%). As a recent IPO with plenty of cash and little debt, Dutch Bros isn’t high-risk in the same way that Carvana is and isn’t facing any existential threat. But the company trades at a sky-high valuation of over 90 times forward earnings in a market that has lost its appetite for these high-multiple stocks and will thus punish them with a sell-off for any misstep, which is why the stock is down almost 50% year to date. There is still plenty of risk ahead, especially at a time when inflation and high gas prices seem to be a headwind to demand.

But the potential reward here continues to be enticing. The West Coast-based purveyor of coffee and energy drinks with names like Vampire Slayer and Double Rainbro is a hit with younger consumers and is ramping up its store count. Dutch Bros is expanding beyond its home base on the West Coast as it looks to execute on its goal of 4,000 locations nationwide over the long term.

Dutch Bros recently opened its first locations east of the Mississippi River in Tennessee, and if its popularity in the western United States translates to the East Coast, there is a massive market opportunity ahead. With about 600 locations now, there is plenty of execution risk, and tastes can change over time. However, if Dutch Bros keeps executing on its plan and becomes a household name or the next Starbucksearly investors will be rewarded for tolerating some risk.

For investors with a diversified portfolio who can stomach some risk, the upside to a few well-placed high-risk, high-reward positions in a portfolio can be significant.

Michael Byrne has positions in Carvana Co. and Dutch Bros Inc. The Motley Fool has positions in and recommends Starbucks. The Motley Fool recommends the following options: short October 2022 $85 calls on Starbucks. The Motley Fool has a disclosure policy.

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