The Folly of Betting on FAANG
What do Alphabet, Amazon.com, Apple, Meta Platforms (formerly Facebook) and Netflix have in common? They’re members of FAANG, arguably the stock market’s most exclusive club in early 2022.
The quintet’s combined market value is a stratospheric $7.2 trillion. That’s more than 18 percent of the S&P 500, nearly half the total value of the Nasdaq 100 and just a bit less than 15 percent of the capitalization of the entire US stock market.
Bottom line: If you own stock ETFs, FAANG performance is probably the single biggest factor shaping your returns. Nothing else comes close.
Up to now, that’s been a very good thing, as their 10-year average annual return of 28 percent is twice the S&P 500’s 14 percent. But FAANG stocks’ superior returns have also made them expensive, with an average price-to-earnings ratio of 35 versus around 23 for the S&P 500. Only Apple pays a dividend. And its token half a percentage point makes even S&P ETFs’ roughly 1.2 percent appear generous.
Lofty valuations like these are a clear sign of extremely high investor expectations. And it’s easy to see why these five companies have earned them: They’re considered America’s national technology champions. In fact, I’d wager most of us would have a hard time going through a full day not using at least one of their products or services.
But lumping all of these stocks together into a single ETF—as though the underlying companies’ fates are somehow interlinked—has become increasingly dangerous and counterproductive for investors.
Take the market reaction to their recently announced Q4 earnings and guidance. Meta/Facebook shares now trade almost $100 below their price when management forecast just 3 to 11 percent sales growth for Q1.
The company did post massive gains of 37.2 percent and 36.6 percent for 2021 revenue and earnings per share, respectively. But the guidance was well below what its fans had hoped for. And the stock’s one-day crash took ETFs with heavy FAANG exposure sharply lower.
That included the Nasdaq 100 ETF traded under the symbol “QQQ,” which dropped more than 4 percentage points. Then the very next day, Amazon.com reported 22 percent higher 2021 sales and raised the price of subscribing to its Amazon Prime service by more than 15 percent. That clear sign of market power pushed up the company’s stock 15 percent in a day.
Amazon’s move erased about a quarter of the QQQ ETF’s losses of the previous day. But the more important takeaway is the company’s stock outperformed Meta/Facebook by more than 30 percentage points over just a two-day period.
How can investors pick the best performing FAANG stocks and avoid the rest? Start with what these companies actually do as businesses, which isn’t as similar as you might think.
Each company has combined rapidly evolving information technology and innovation to build novel, fast-growing businesses. But while Meta/Facebook calls itself a “social technology company,” virtually all of its income is from online advertising, a rapidly shifting hyper-competitive arena.
Netflix is now far from alone providing Internet streaming services, though it arguably has a content advantage over most rivals. And while Apple has a still unmatched reputation for innovation and high quality, it’s fundamentally a maker of devices facing unprecedented and rising global competition.
In contrast, Amazon.com and Google have arguably managed to convert their core businesses into essential services, and while largely avoiding the regulation faced by utilities. That’s the subject for another Substack post. And as long as they can pull that off, their growth is likely to prove far more sustainable than that of the other three FAANG stocks.
I’m not particularly keen on buying any of these stocks at current levels. So far this year, momentum has been running against all five. And current high levels of valuation don’t offer much in the way of support for prices.
But being aware of the differences between these five companies—rather than them lumping together as big media does—will help us buy intelligently when we do again see good entry points. And we’ll avoid fallout when the FAANG companies most exposed to competition inevitably stumble again.