FAANG stocks: biggest bubble or biggest opportunity?


FAANG is the acronym for the group of tech mega-cap stocks that are have been rocking global markets on the upside in recent years and some believe, are now threatening to rock them the other way around. The famous five of FAANG (a term coined by CNBC's Jim Cramer) refer to Facebook, Amazon, Apple, Netflix, Google (now its listed parent Alphabet). Their combined market cap in Jan 2017 was a huge $1.84 trillion. In the next 6 months, that grew by a further 30% to an amazing $ 2.38 trillion - that's bigger than India's GDP ($2.26 trillion). Does the rapid rise in their share prices represent a huge bubble that is bound to burst and hurt everyone badly? Or is it a recognition of the global dominance of these companies and the boundless new opportunities that they can capture globally as they relentlessly disrupt one business after another?

FAANG market scene


The charts above tell you the story of the FAANG mania that's gripped world markets. Do valuations justify this mania? According to Goldman Sachs, Amazon is trading at a price-to-earnings multiple of 89, vs. an average multiple of 58 for the core dotcom bubble stocks back in 2000. Free cash flow margin stands at 7 per cent for Amazon vs. 19 per cent for the dotcoms in 2000, while return on invested capital stands at just 10 percent vs. 16 percent. (Anthony Mirhaydari Moneywatch June 9, 2017).Overall, oilfield services, energy exploration and production stocks are down 20%, while tech stocks have gained 19% in the last year. Amazon is not the only one with these kind of rich valuations - it's a thread running across FAANG stocks.

A factor that global equity markets are watching out for is the Federal Reserve's tightening cycle. The futures markets have already priced in a quarter percent hike and expect another couple of hikes through 2019. But the Fed policy seems to be much more aggressive.The Fed might hike twice this year and also slow purchase of bonds. Further, the US economy and indeed the world economy is not doing all that well, while many actual earnings are coming in below expectations.

What then exactly is going on? One answer could be that investors are looking for relative value.

June jitters

Back at the beginning of June the FAANG stocks did indeed cause jitters. The NasDaq dropped 1.8% on a single day, recovering from anintraday fall of 3% as FAANG stocks were hammered. The main reason for the nightmarish selloff was a pessimistic report about FAANG stocks from Goldman Sachs, which warned that these stocks were likely to hit an 'air pocket', meaning market volatility. This was buttressed by a Merrill Lynch report that said that many large cap funds were exposed to these stocks by margins which were comfortablyin excess of the dotcom bubble. These stocks seemed to thrive because investors were following momentum for its own sake. Once the momentum was reversed, people wanted to get out at any cost, hence the market mayhem.

That FAANG stocks are a risky proposition cannot be denied even by their diehard supporters. Investors can reasonably desire a return of 10%. But the recent surge in stock prices has made that difficult to achieve. At the beginning of the year the PE multiple for these stocks, taken together as a whole, was 23. By June that had climbed to 31. Quarterly earnings are in the region of $80 billion. On this basis, the valuation should be $2.4 trillion. These companies pay very little dividend with only Apple paying regular dividends. Thus to reach the 10% growth mark, the stocks have to increase by 9.5% annually. Yet earnings will have to grow faster to maintain this sort of growth in stock prices. Since these stocks are held as long term investments, out to 2026, share prices would have to rise 147% to maintain the 9.5% growth rate. Since PE is likely to drop to 25, earnings will need to triple, an annual increase of 11.2%. This will be very difficult to achieve.

Recovery and boom

Yet by the end of July, FAANG stocks were on the march again, reaching ever greater heights, pushed by strong quarterly earnings. Amazon's and Netflix's earnings exceeded expectations by wide margins. Netflix's subscriber base surged in the quarter, further pushing up share prices.

Amazon's stock is up 36% this year, hitting $1,000. Wall Street analysts allocate a price target of $1136. "I'm pounding the table on Amazon, there's no question about it. They are going to report a good quarter, Street numbers are going to go higher, and I think the stock is going to soar. I think it could be a 6 percent move, so I look at it and say it's easily a nice long trade into the quarter, into earnings next week," said Seaburg, head of sales trading at Cowen and Co, on CNBC's "Trading Nation."

Amazon has invested heavily in content in the earlier year and in fulfilment centres and such investments are expected to taper off in the second half of this year, allowing greater positive cash flows. "You look at their Street numbers, as far as their operating income numbers, they're incredibly low. I think they're looking for $550 million, which implies a 1.5 percent operating margin. ... If you look back 10 years, I don't think it's been that low," he added.

However not all FAANG stocks are doing well. Indeed many investors are abandoning Apple for the other FAANG stocks. According to Matt Maley, Millerr Tabak equity strategist, "Let's face it. Apple still generates huge amounts of cash, and I just wonder if we will get a 'buy the news' situation, either when earnings come out or when they announce the iPhone 8, and see if they can break out," Maley said on "Trading Nation." (cnbc.com, Rebecca Ungarino, July 24rth, 2017).

Where does it all end?

Others look at the scenario very differently. According to this school of thought, it is scaling which really allows FAANGs to dominate. By its very nature, the digital business creates a few huge winners and a larger group of losers. These digital giants have tremendously disrupted traditional business models and sectors. Disruption on this scale gives the FAANGs an edge over the others.These companies have adequate cash flows and valuations have not yet reached bubble proportions.Further these companies have treated their shareholders so well, that many investors are loathe to sell their shares.

Writes Sam Peters, CFA -'in tackling this scaling question, our team had the great fortune of reading a brilliant new book, Scale, by Geoffrey West. In the book, West tackles the underlying structure of scale for a broad set of areas, ranging from organisms to cities, and also fortunately for our purposes, companies. His scaling framework assigns a scaling exponent that is either superlinear and above 1, or sublinear and below 1.For superlinear categories that scale above 1, like cities, innovation drives increasing returns with scale and an infinite life span. Sublinear categories, such as organisms, scale below 1 and must endure the realities of bounded growth and a finite lifespan'. (seekingalpha August, 4, 2017).

To explain scaling, FAANGs revenue and income growth versus employee headcount growth is compared in the diagram below. FAANGs scaling ability exceeds that of the market.

Growth of Revenue with Headcount (1990-2016)


This huge relative scaling can explain the FAANGs advantage and the way they have managed to disrupt existing business and attract revenues and profits to themselves.Scaling of net income relative to employees shows that they don't need a huge pool of labour to produce profits.

Growth of Net Income with Headcount (1990-2016)


Source: FactSet (seekingalpha August, 4, 2017).

Factors discussed above could be the reason why these companies have so much market capitalization and continue to defy gravity. Apart from direct investors, passive investment products are also chasing the FAANG stocks. As of now this juggernaut seems set to roll on.

The cautionary tale here is that there were many asset classes in the past too, like housing, which people thought would never dip in value. Further, investors are now dependant on a very narrow base of a few companies for future well-being. New businesses, new technologies and events have the capability to adversely affect this halcyon future. Looking to the long term, investors should think more deeply and widely about the market to provide a margin of safety while investing.

Would analysts say FAANG stocks provide a margin of safety? Or would they say they are now priced for perfection - ie no hiccups visible whatsoever in growth over the next 10 years? Answers to these questions may perhaps give us clarity on whether buying FAANG stocks today represents buying into a bubble or into the next big opportunity that you cannot afford to miss.

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Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !

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