Should you sink your teeth into FAANG stock trades?

Facebook, Amazon, Apple, Netflix and Google make up more than 25% of America’s benchmark S&P 500 index gains this year. The numbers these stock trades, collectively nicknamed FAANG, have racked up for investors are eye-watering. Can this performance continue? 

F – Facebook is up +44.5% YTD, +33.1% over 12 months

A – Amazon is up +26.6% YTD, +22.9% over 12 months

A – Apple is up +38.0% YTD, +49.4% over 12 months 

N – Netflix is up +34% YTD, +70% over 12 months

G – Google is up +17.4% YTD, +17.3% over 12 months 

Most of the above FAANG stocks appear classic momentum investing. Some fear these tech stocks are over-bought. They cite dot.com worries, circa 2000, when tech stock trades crashed and burnt, as well as still relatively weak US consumer spending. 

Plus, there has been a rash of underwhelming earnings wobbles. Wall Street analysts, for example, anticipated Amazon’s recent second quarter earnings would land around $1.42 per share. The reality was massively adrift at just 40 cents per share. Shocking numbers. 

The online retailer titan claims expansion, sales and overall subscriber numbers (which came in better than expected) is the real story – The Earth’s Biggest Shop, as it is being called. Amazon’s talk is of vision and leadership. But its profits continue to be slender.

Amazon profits not yet prime: Shutterstock

What profits voodoo is this?

Let’s prop up the bonnet and take a proper look. First, the loose FAANG moniker contains very different companies. Yes, Facebook, owner of Instagram and WhatsApp, has a strong tech element. But it’s also an extremely powerful advertising company.

Facebook has more than two billion users. And those two billion users have real pulling muscle for advertisers. For the April to June quarter this year, Facebook revenues leapt 45% while profits surged more than 70% to $3.9bn. Mobile adverts account for 85% of Facebook’s advertising revenues.

In contrast, Amazon, the biggest US online retailer, with 33% of the US online market according to Euromonitor (and with the potential to grab much more), saw its second quarter income slump 77% to just $197m (40 cents a share).

Zuckerberg is focused on ads rather than tech: Shutterstock

Reality check, please

But Amazon’s net sales for the second quarter were worth $37.96bn, up 24.8%. Professor Ruth Bender of Corporate Financial Strategy, Finance and Accounting at Cranfield School of Management told Capital traders need to separate the price of a company and the value of a company if they’re to understand the accounting maths.

“The price is what you’re willing to pay and the value is what it’s [the company] worth.” Amazon is tricky to value objectively, she says, because it’s thrown itself at so many different sectors.

“I do know, though, that Amazon’s core cloud operating business is immensely profitable. It’s because Jeff Bezos [Amazon founder and CEO] is flinging cash at things that may or may not take off. But you can still value Amazon.”

Valuing Amazon is tricky but possible: Shutterstock

Valuations evolve

One of the difficulties in valuing online retail companies is understanding how they make money and how those profits are understood and projected, be it for stock trades or longer-term investments.

For example, in the late 20th century Walmart grew by building new bricks-and-mortar stores as well as exerting huge pressure on suppliers to keep prices low. The likes of Amazon or Facebook, in contrast, grew via digital marketing.

Digital marketing expenses are typically taken as a charge on profits and loss. Capital expenditure, in contrast, hits the balance sheet. That makes it harder to know how profitable or efficient a company is because a balance sheet encompasses capital-intensive assets that digital, often highly ‘disruptive’ companies, often, have no need for. 

“While Walmart had higher accounting profits, its business model was naturally more capital intensive,” wrote Orbis Investment Management recently. “Accounting profits are one thing, but in terms of generating all-important cash flows, it’s Amazon’s business model that turns out to have been the more profitable.” 

In other words, each business must be scrutinised on its merits.

Digital business has to focus, and measure, cashflow: Shutterstock

Stickiness is huge

One crucial profitable value – the value every company wants – is stickiness. A quality Apple, not to mention Facebook, has a super-abundance of says Ruth Bender.

“Apple’s biggest asset is its logo. It ties us all into its infrastructure. If you have ‘stickiness’, it makes your company worth a lot more. But if you’re an asset-rich company but rely on having to keep buying assets then that eats into cash flow.”

In that sense Apple, Netflix, Amazon and Facebook have plenty in common. Not so long ago it was suggested Apple’s chief asset was its ex-boss CEO Steve Jobs, who died in 2011, but the potency of the Apple logo, and the brand loyalty attached, shouldn’t be under-estimated.

But plenty of stickiness doesn’t mean you’re insulated from traditional economic pressures. Jason Hollands from financial advisers Bestinvest says Facebook is still exposed to the vicissitudes of an advertising downturn – like any other business, digital or non-digital.

There’s also rising anxiety about the massive positions in FAANG stocks taken by tracker funds helping propel valuations skyward.  

Steve Jobs – a case of extreme 'stickiness': Shutterstock

Traditional fundamentals revert?

“Earnings [Facebook] can become quite variable depending on the economic conditions of the time.” He goes on: “There is quite a lot of simmering concern of premium valuations driven so high over a long period of time…you end up with these big positions of portfolio companies on what seem eye-popping valuations on most traditional measures, many of which don’t pay a dividend.”

Throw in quantitative easing and rock-bottom global interest rates supplying masses of cheap cash and it’s little wonder a surfeit of money has found new homes in the market. 

“When you look beneath this, a large part of it is down to the small cluster of so-called tech-type stocks. But no bull market runs for ever,” he adds. “Think of any type of ‘trigger’ event. It could be North Korea. Money starts coming out of the markets.” 

In a crisis, many fund managers would remain invested in businesses with reasonable balance sheets and cash flow. But a good chunk of retail investors, deeply invested in tracker funds, might think otherwise suggests Hollands. He thinks Facebook looks the most vulnerable FAANG name.

Tanks on the streets of Pyongyang. Could Kim Jong-un be the trigger for a FAANG collapse? Shutterstock

A maturity lesson

Bear in mind some FAANG stocks are now way past ‘growth fund’ status, even accruing some salt and pepper in the corporate hair. Google’s (or rather Alphabet’s) interests now range from electric cars to artificial intelligence, and the same goes for Apple. Amazon is getting into groceries and organic food – witness the $13.7bn buy-up of Whole Foods.

Yet despite their success and ubiquity, FAANG stocks aren’t the ball-breaking gods some think. Bricks and mortar retailers are now narrowing the gap when it comes to online shopping, says senior credit officer Charles O'Shea from Moody’s Investor Services. 

“The online giant [Amazon] is still a long distance from ruling retail,” he says. “Amazon's stock has been outperforming that of other retailers based largely on the promise of further expansion and potential expense reductions, but aside from sales growth, the company doesn't perform as well as the largest US retailers.”

Is the Amazon-Whole Foods threat overstated? Shutterstock

Not so prime

O’Shea also says a fair amount of murk remains around Amazon’s guidance on its monthly Prime fee membership base – claimed to be 85m by some pundits – which costs $99 a year in the US and £79 in the UK.

“Moody's calculations,” says O'Shea, “based on demographic information, suggest Prime membership is closer to 50m against, for example, Costco's paid membership of 47.6m.” 

The US food sales market meanwhile is worth $800bn a year, of which Walmart sells more than $200bn. "We believe it's a big stretch to say Amazon will dominate the US food retail business in the next two years," O'Shea adds. "Even with Whole Foods in its basket, its food sales still amount to less than $20bn annually.”

So there are pros and cons to getting your teeth into FAANG stocks. Do your research and decide if now’s the time to bite, or not.

Don't under-estimate the power of traditional bricks-and-mortar players. Some are learning new tricks fast. Shutterstock