Reality Check for FANG & Friends
September 3, 2019
The math is clear — the S&P 500 has outperformed everything else over the past decade, and it’s largely due to the performance of just six stocks. Facebook, Amazon, Netflix and Google were anointed the FANG stocks on CNBC’s show Mad Money back in 2013. As tech heavyweights Apple and Microsoft gained momentum, the name was elongated to FAANGM. That’s hard to pronounce, so we’ll refer to the group as “FANG & Friends.”
To be sure, FANG & Friends dominate the fields of e-commerce, mobile devices, streaming video, cloud computing, and social media. Their innovations continue to transform our daily lives. As a result, these companies tend to be treated as a monolith by the media, politicians, and market observers. However, there are differences in their business models that have major investment implications regarding risk, valuation, and regulation.
FANG and Friends differ significantly in how their products and services are sold, ranging from transactional to usage or subscription based. Amazon (selling seemingly everything) and Apple (selling electronics hardware and apps) are thought of as transactional, yet both have significant subscription offerings. Cloud services pioneered by Amazon, Google, and Microsoft are usage based -- businesses and consumers utilize storage and computational space in these companies’ data centers and pay based on how much they use. Facebook and Google’s advertising model can also be described as usage based (making money ‘per view’ or ‘per click’). Netflix is a pure recurring subscription service – customers pay a fixed monthly price in return for access to the entirety of its video library. A large portion of Microsoft’s software revenue is now generated via annual subscription fees as well.
The market typically ascribes lower valuations to transaction revenues due to their lumpy nature and tendency to be more cyclical and awards higher valuations to recurring subscription revenues, as they are easier to forecast and less volatile. Usage based services tend to fall somewhere in between. This valuation continuum has led to a consistent theme among FANG and Friends – all are trying to introduce and grow usage and subscription-based services.
Looking at handy stock valuation ratios like price/earnings and enterprise value/sales, FANG & Friends currently trade at multiples ranging from in line to significantly higher than market averages. We prefer a more nuanced approach that ascribes greater value to predictable, repeatable revenues and adjusts for leverage and cash accumulated on the balance sheet. Perhaps the most difficult aspect of pinpointing intrinsic value for this collection of stocks is divining a suitable long-term growth rate (revenues have grown at annualized rates from 6% (Microsoft) to 70% (Facebook) over the last ten years). In such cases, it can be illustrative to back into the long-term future growth rates implied by the current stock valuations. Thus, the question becomes, “Is it realistic to assume that Microsoft, Netflix and Amazon can grow operating income at 4-5% in perpetuity or is the 1-2% implied long-term growth for Apple, Facebook or Google a more comfortable proposition?” Forever is a long time and, all else equal, we prefer lower expectations.
Beyond valuation deliberations, we have concerns about the sustainability of Facebook’s business. Its advertising-driven model isn’t fundamentally wrong but the current culture at Facebook strikes us as misaligned, with the company flaunting confidentiality concerns and turning a blind eye on misinformation. In contrast to Google, which also generates significant revenue from advertising, Facebook’s utility seems limited. We use Google’s various services extensively for research and other purposes. At home, YouTube has become a trusted source of information for DIY projects and, in our schools, to learn about faraway places and scientific discoveries. While not perfect, we believe Google is helping move the world in the right direction and is making important improvements in promoting content from well-respected sources while demonetizing and marginalizing misinformation and questionable content (a daunting task that is sure to always upset one constituency or another). Apple’s platform is different still. It charges for its products and is thus not dependent on user data to generate earnings, which in turn affords it greater control over privacy and content. In our minds, Apple is further differentiated by its brand power and excellent corporate governance.
It’s impossible to discuss large technology companies without touching on regulatory risk, related to both privacy and anti-trust rules. Facebook, followed by Google, will likely continue to receive the most scrutiny related to privacy. But the best step forward for all of these companies is to clearly and concisely tell their customers what information is being collected, how it’s being used, and how/if users can “opt out.” Consumers should educate themselves on the business models of the companies they share their information with – especially when it appears they are getting something for free. Google is the most likely to receive anti-trust attention. However, we think that even if the most extreme outcome were to come to pass (regulators force Google to break into pieces a la AT&T in 1982), there is reason to believe shareholders could still do well. Furthermore, observing Google’s (strong) results in Europe in the wake of rules meant to target their omnipresence only reinforces our belief that complicated legislation often ends up benefiting the largest incumbents.
When considering both current valuations and our views on long term sustainability, Apple and Google stand out to us among FANG & Friends. This isn’t meant to be a recommendation but rather a (small) window into our thought process. As always, you know where to find us if you want to continue the conversation.