Origami

Can the FAANGs keep flying high?

3 months ago

The best performing stock in the S&P 500 in 2020 to date may be a goldminer, Newmont (see Shares, 14 May 2020), but 10 of the top 20 names are tech stocks of various colours and 5 more are pharmaceutical or biotech plays.

Tech and pharmaceuticals dominate the S&P 500 leaderboard in 2020

Source: Sharepad

Two – Netflix and Amazon – are part of the FAANG quintet, along with Facebook, Apple and Google’s parent Alphabet. All five names are up on the year, compared to a 13% drop at the time of writing in the S&P 500. As a result of their stunning long-term performance, these five firms are now worth almost 18% of the S&P 500 on their own (and twice as much as the entire FTSE 100).

“As a result of their stunning long-term performance, Facebook, Amazon, Apple, Netflix and Google’s parent Alphabet are now worth almost 18% of the S&P 500 on their own (and twice as much as the entire FTSE 100).”

A sixth tech name, Microsoft, is the world’s biggest firm by market cap, a fraction ahead of Apple. Throw that into the mix, and this sextet is currently being valued at $4.3 trillion, or 24.7% of the S&P 500.

Six tech names dominate the S&P 500

Source: Refinitiv data

Put another way, over the past 12 months, the S&P’s market cap has grown by $187 billion. These six stocks have added $1.5 trillion, which does not say much for the other 494 members of the American benchmark and begs several questions for anyone with exposure to US equities.

“Put another way, over the past 12 months, the S&P’s market cap has grown by $187 billion. The five FAANGs plus Microsoft have added $1.5 trillion, which does not say much for the other 494 members of the American benchmark.”

 

  • Is such a narrow-looking market as healthy as it seems?
  • Do holders of passive or tracker products know that their money is so exposed to just six stocks, when what they will really be seeking is diversification?
  • Does this help or hinder the active managers which investors pay to generate outperformance, if six stocks are so dominant?
  • Will the FAANG stocks, plus Microsoft, continue to perform so well in both operational and share price terms? Or will margins and valuations revert to the mean over time, permitting new stock market or technology leaders to emerge?

 

Six of the best

It is easy to see why the FAANGs are still doing so well, even in 2020, despite all ultimately being very different businesses.

  • They are all essentially digital, flexible, platform businesses that can control costs, maintain service standards and still fulfil customer needs even during these difficult times.
  • Their value lies in intellectual property, not physical assets (even if how they obtain and use some of the IP, in the form of customer data, remains a bone of contention for some).
  • They have strong balance sheets (with Netflix the exception), as evidenced by a combined net cash pile of $212 billion, a figure that has barely changed since the end of 2014 despite $290 billion in capex and $450 billion in dividends and share buybacks. This in turn evidences their powerful profit margins (average 17.7% in 2019) and strong free cash flow, which has come to $485 billion in total since 2014 (even though Netflix has contributed only outflows).

FAANGs continue to generate plenty of cash

Source: Company accounts

Companies generally falter because customers and clients either get fed up with them and seek an alternative or their bounteous margins, cash flow and returns on capital attract capital and competition, which relentlessly chip away at all three. While Netflix probably faces the greatest number of new rivals, the others still look difficult to dislodge.

Price and value

So far so good. But then how much of this is news? Not much, judging by the stellar share price performance and valuations. The FAANGs’ monster market cap means that they trade on 37 times forward earnings for 2020, although forecast rapid earnings growth of 34% for 2021 and 19% for 2022 means that drops to 23 times in two years’ time.

“If consensus earnings forecasts of a 34% leap in profits in 2021, followed by a 19% surge in 2022, prove accurate, the FAANGs could well remain all-conquering. But consider that aggregate net income fell 2% in 2019 and is forecast to drop 4% in 2020.”

 

And here is the nub of the issue. If those forecasts prove accurate, the FAANGs could well remain all-conquering. But consider that aggregate net income fell 2% in 2019 and is forecast to drop 4% in 2020, as Amazon piles on the costs and Alphabet and Facebook encounter a squeeze on ad spending, and those growth estimates may look aggressive. And that would leave buybacks and dividend exposed, as they exceeded total free cash flow generated in 2018 and 2019.

 

Just like the rest of the US market, FAANGs are expected to shake off 2020’s loss of momentum

Source: Company accounts, consensus analysts’ forecasts, Zack’s, NASDAQ

But that still begs the issue of what could lead to the sort of earnings disappointment that persuades growth-hungry investors to move on, if customers still seem happy to pay for the services on offer (or accept access to their data as payment in kind, in certain cases)?

Regulation is still a possible source of difficulty, with Amazon set to be hauled before Congress to explain how it uses data and Apple, Alphabet and Facebook all still looking over their shoulders after prior disputes with the taxman, anti-trust regulators or privacy campaigners. And how politicians react remains as unpredictable as ever.

“Regulation is still a possible source of difficulty, but perhaps the biggest potential challenge would come from a different source: inflation.”

 

Perhaps the biggest challenge would come from a different source: inflation. Investors warm to growth stocks – and pay high multiples for them – because there is little reliable growth around. If government and central bank stimulus programmes designed to fight the virus do lead to an unexpected bout of inflation, cyclical growth will be just as easy to find as secular growth, if not easier, and it will come at a fraction of the price. But then many famous names have fallen from favour while waiting for ‘value’ as a style to return, have they not?

 

Author
Profile Picture
Russ Mould
Name

Russ Mould

Job Title
AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

Financial adviser verification

This area of the website is intended for financial advisers and other financial professionals only. If you are a customer of AJ Bell Investcentre, please click ‘Go to the customer area’ below. 

We will remember your preference, so you should only be asked to select the appropriate website once per device.

Scroll to Top