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The technology sector trades at a premium to the broader market but is far from the “blue sky” territory witnessed in the run up to the early 2000 tech bubble.
Passive ownership presents no more risk to FAANG than it does to the broader market.
Not all FAANG are created equal - the individual companies are widely dispersed in terms of both quality and valuation.
The last couple of weeks have elevated FAANG constituents (Facebook, Apple, Amazon, Netflix and Google – now Alphabet) to the spotlight, once again, with no shortage of headline-grabbing events for the media to turn their attention to.
Last week, Apple became the first listed company to exceed a market capitalisation of one trillion dollars. Amazon became the target of the UK press after a record breaking year (with its UK profits increasing from £24.3 million to £72.4 million) resulted in a 38% fall in its UK corporate tax bill – go figure? The week before, Facebook saw $123bn wiped of its market value (the biggest one day loss of all time) after its shares fell 20% following its latest results update. It’s crime? The Company announced that active-user growth had slowed and the CFO guided to both lower revenue growth and contracting operating margins (a mere 37% year-over-year and margins in the mid-30%). Prior to that, Alphabet was hit with a record breaking European Commission antitrust fine (to the tune of €4.34bn) for practices surrounding its mobile operating system, Android and Netflix shares fell double digits after reporting weaker than expected subscriber additions.
For an industry whose profits are directly correlated to the number of clicks they can generate – it’s hardly surprising that an onslaught of FAANG inspired articles followed – less focused on presenting the facts and more concerned with capturing the attention of their audience. The irony of writing this article in response is not lost on us, however, as long-term holders of Apple (and more recent holders of Alphabet) we feel it is important to distinguish between those comments which are nothing more than click bait and those which may, indeed, have some merit (and thus the potential to threaten or strengthen our investment rationale). What follows is our analysis on some of the myths surrounding FAANG (and the broader technology sector), hopefully leaving you with the facts that will enable you to determine whether an exposure to such companies is justified.
“The tech sector is now reminiscent of the 1990s dotcom bubble”.
Source: Jim Paulsen as reported on CNBC 8 June 2018
Chart 1 below shows the aggregate, forward looking, price earnings ratio of the MSCI World Technology Sector versus the broader market over the past 20 years. Whilst the sector is trading at a premium to the broader market (currently 22%) we are by no means in the “blue sky" territory of the late 1990’s early 2000’s. As a comparison, for a brief period of time running up to the demise of the dotcom bubble, the technology sector was trading on close to a 200% premium to the market (see the black dotted line).
Perhaps what is more interesting about this chart, and what often goes unnoticed, is that even after the bubble burst in the early 2000s the premium to the market, at its worst, was still higher than it is today. In fact, the premium remained significantly above the current level until the 2008 financial crisis, where it briefly fell to 14%, before recovering to the high 30s in 2009. As tech earnings began to recover post-crisis, the PE ratio fell in line with the market - where it remained until the start of 2017.
Expressed another way, if we look at the relationship between the market value and net income of the technology sector as a percentage of the broader MSCI World Index today versus the same figures for 1999 the picture paints two contrasting stories:
In 1999, the market capitalisation of technology companies accounted for 22% of the index but contributed only 10% to its overall net income. Today, the technology sector accounts for 17% of the index and contributes 14% of overall net income. It’s worth noting, for later discussion, that on the same basis FAANG stocks currently account for 8.5% of the MSCI World Index in terms of market cap and have contributed 6.2% of total net income.
Our view: Whilst the technology sector is certainly not as cheap as it has been in recent years, it is far from the heights the sector reached in the run up to the dotcom bubble. As a result, we struggle to see the comparison as even remotely fair.
Technology remains one of our core investment themes and one we believe will be a future driver of performance. If continued innovation within the sector transpires to superior cash flow growth then a valuation that is at a slight premium to the market is certainly justified. That being said, company valuations are an aspect we pay particular attention to and we actively seek to avoid companies which are trading in excess of what we believe their true intrinsic value to be.
“ETFs may have accentuated the flow of capital into FAANG and when this ends it will be worse for those stocks than for the rest”.
Source: Howard Marks as reported at the Delivering Alpha Conference on 18 July 2018
This comment implies that the tide of money working its way into financial markets through passive investment vehicles such as Exchange Traded Funds has helped elevate FAANG stocks to their current values at a rate that is quicker than the broader market (demand-pull inflation). Moreover it implies that ETF ownership is greater in these stocks than then broader market so that when (if) this capital flow reverses the result will be more detrimental to this collective group than the rest.
We’re not disputing ETF flows have a growing influence in financial markets. As a barometer, we looked at the largest companies in the US across all sectors and we acknowledge that passive ownership now accounts for a not too trivial proportion of total share capital (see our tables below). However, it is hard to see any evidence that FAANG are more reliant on ETF capital than the broader market.
Our view: It appears to us that FAANG are no more exposed to the threat ETFs present than any other (US) companies we have looked at. As a percentage of total ownership, passive ownership represents a lower portion within the FAANG stocks than the broader market.
In addition, market data suggests FAANG stocks are traded more frequently and are more liquid than the broader index as a result. This is an important factor as it will be the less liquid shares that are most heavily penalised in a, passive-driven, liquidity squeeze. The theory of supply and demand suggests that the influx of sellers will quickly saturate the normal volume of buyers, resulting in share prices being driven lower. Should such a scenario unfold, it is likely to be the sellers that lose out – forced to accept lower prices in order to attract buyers.
Erratic market movements have no impact on a company’s intrinsic value. As long-term holders, such unjustified movements should be viewed as attractive buying opportunities however, that is not to say that the temporary adverse impact on share prices won’t be painful to endure for existing holders in the short term. The ability to hold your nerve and weather bouts of volatility is essential for long-term investment performance.
"Not all FAANG stocks are equal".
Source: Bob Pisani as reported on CNBC on 17 July 2018
This is a defence we are encountering more frequently. As bottom-up, fundamentally driven investors (who own two out of the five FAANG companies), it’s probably no surprise that this is a comment we agree with! However, preconceptions aside, is there any measurable truth behind the phrase? The table below is as good a starting place as any.
There are of course many other metrics we could have chosen (and the above certainly does not represent a full picture) however, the metrics do highlight a clear divide within FAANG – companies which are highly profitable, possess a robust balance sheet and are cheap (relatively!)- Facebook, Apple and Google -versus those which are trading on elevated multiples, generate minimal income and have less cash (or cash equivalents) in reserve– Amazon and Netflix.
You may recall earlier in this article we commented that FAANG stocks made up 8.5% of the MSCI World’s market capitalisation and contributed 6.5% to total net income, suggesting that FAANG, as a subset, are still not pulling the entirety of their weight. However, this aggregation masks the discrepancy within FAANG holdings which the chart below illustrates.
Apple makes up only 31% of the market capitalisation of FAANG but contributes 50% of all FAANG net income, Facebook also contributes more significantly to net income than its market capitalisation would imply and Google (Alphabet) is punching pound-for-pound (24% of total FAANG market capitalisation and providing a 24% contribution to group net income). Amazon on the other hand, accounts for 27% of FAANG market cap but only contributes a mere 7% to group net income. A similar situation is true for Netflix (which makes up 5% of market capitalisation but 1% of net income).
Our view: Individual companies within FAANG offer, at least from our perspective, differing degrees of quality. For the purpose of the Blue Chip Strategy, Amazon and Netflix do not meet our stringent investment criteria. In the fullness of time that may change however, we would want to see that supported by improvements in the “hallmarks of quality” we look for prior to making an investment. Allocating capital on the basis of speculative claims about what a company may become in the future is an action we discourage. Instead, we prefer to allocate our investors' capital to companies where the fundamentals of the business already justify the current valuation; preferably when these qualities haven’t been fully appreciated by the market and we can pick up the company at an attractive price.
When it comes to FAANG, we have yet to come across any convincing arguments that render our investment rational (in either Apple or Alphabet) redundant. That being said, we remain open to the fact that, at any time, we could be presented with information that may challenge our view. The strongest investments are those which continue to be challenged but where the investment rationale is solid enough that it cannot easily be debunked. In times of heightened media scaremongering (such as this) we take comfort from the robustness of our investment rationales formed through our intensive research process. These give us the confidence to remain focused on the long-term objective of the Strategy and those of our many investors.
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RISK WARNING: The value of investments and the income derived from them may go down as well as up and you may not receive back all the money which you invested. Any information relating to past performance of an investment or investment service is not a guide to future performance. Fluctuations in the rate of exchange may have an adverse effect on the value, price or income of non-sterling denominated investments. The fund has a concentrated portfolio which means greater exposure to a smaller number of securities than a more diversified portfolio. The fund may experience greater volatility as a result of this.