June 29, 2018

Is the FAANG Phenomenon Sustainable?

We recently wrote about the FAANG stocks, and the degree to which they currently dominate the stock market. These five companies — Facebook, Apple, Amazon, Netflix, and Google (parent company Alphabet) — represent more than 12% of the S&P 500 Index, and more than 27% of the NASDAQ. This raises two important issues: the first is simply the concentration of the public stock market, which we discussed in our recent post. The second is the growth curve of these behemoths; can they sustain their massive growth, and for how long?

Because the S&P 500’s recent growth has been largely driven by Technology, and greatly by the FAANG stocks, this handful of companies plays an extremely important role in the market. For instance, YTD (1/1/18 – 6/29/18), the FAANG stocks contributed more than 83% of the S&P 500’s return – in other words, five companies made up 83.2% of the total return of the index, and the other roughly 495 were responsible for only 16.8% of the return. We took a look at two critical factors of these stocks — their P/E ratios and PEG ratios — and found some interesting data.

The FAANG’s P/E ratios, or price-to-earnings ratio, compare the companies’ stock prices with their earnings. This ratio is often used to indicate whether a stock is over- or under-valued. For context, we’ve included the P/E ratios of the NASDAQ and S&P 500, which are both trading close to their historical averages. Most of the FAANG stocks are within a relatively normal range for those companies, though Amazon and Netflix are well outside of historical averages, and all are trading below or close to their five-year average P/E ratios:

FAANG P/E Ratios (as of June 29, 2018)

                     Current P/E ratio      5-year average P/E ratio

Facebook, FB –         28.5x                             68.4x

Apple, AAPL –          18.0x                              14.7x

Amazon, AMZN –      267.7x                           547.3x

Netflix, NFLX –         248.6x                            221.0x

Google, GOOG –       30.3x                              30.0x

NASDAQ –                23.2x

S&P –                       20.7x

One way to look at a P/E ratio is that it represents the number of years a company would have to maintain its current earnings rate for an investor to recoup their investment if all earnings are paid out. Amazon, for example, would need to continue to earn at the same rate for about 268 years to cover all shareholders’ investments at the current share price. Google, for about 30 years. Netflix would need its earnings to continue at the same pace over the next 249 years. Of course, if earnings grow, the timeline shortens. Again, these P/E ratios aren’t unusual for these companies, given the current environment, but compare them to the average P/E ratio for emerging markets stocks, which is roughly 13.5x. Emerging markets investors would need only 13 ½ years of current earnings to recoup their investment.

We also went a step further and took a look at the FAANGs’ PEG ratios. The PEG ratio is the price earnings to growth ratio, which compares a company’s current share price with its earnings per share against the rate of the company’s earnings growth. The PEG ratio is a good indication of how much growth investors have priced into a company’s current share price. In other words, what do investors expect, and what are they paying for?

FAANG Implied Growth Rates Based on PEG vs. P/E Ratios (as of June 29, 2018, source: Bloomberg)

Facebook, FB – 27.1%

Apple, AAPL – 12.6%

Amazon, AMZN – 137.1%

Netflix, NFLX – 99.7%

Google, GOOG – 26.8%

The share price for Amazon is based on an expectation of 137% growth, Netflix nearly 100%. Even Facebook has more than 27% growth priced into it. These are fairly lofty expectations, with the possible exception of Apple’s tamer PEG ratio.

What does this mean for investors? There’s no crystal ball, of course, and nobody can tell the future. FAANG stocks aren’t unusually priced, given the environment; in this current extended bull market, earnings are not necessarily closely correlated with price. But these companies are the driving force behind the S&P 500, and their prices suggest an expectation of continued growth. Though the FAANGs are definitely looking for ways to expand – Amazon moving into cloud computing, grocery (Whole Foods), and the healthcare system (PillPack), and Netflix creating custom content, for instance – they also each already dominate market share in their markets, and are even starting to compete with one another.

For us, the message is one of diversification. Because the market is so concentrated, people are betting heavily on the FAANG stocks, particularly passive investors, whether they intended to or not (as discussed in our recent post). The FAANGs have certainly proven themselves and may continue to be strong performers. But if they are unable to sustain their growth, the impact and volatility will be felt far and wide. We believe in the importance of spreading risk around so that it is not so easily concentrated, and the FAANG phenomenon is a perfect illustration of why that’s so important. Watch our video, Stand Out From the Crowd, to learn more about Arnerich Massena’s solutions to crowded and concentrated public markets.