By Tom Wickers, Hottinger Investment Management
In October, the Financial Times published an article calling attention to the drab performance of big technology stocks[1]. FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) returns waned in the face of wavering economic confidence over the summer as investors cycled more defensive stocks into their portfolios. Since then, Big Tech returns have rocketed. An analysis of this year’s cumulative returns of FAAMG – which substitutes Microsoft for Netflix and represents the five largest technology companies in the world – demonstrates just how strong their performance has been.
To provide some idea of the size of the FAAMG stocks, they represent the five largest companies in the world[2] aside from the newcomer Aramco. As at the end of 2019, their combined equity values constituted 23.47% of estimated US GDP[3] which is also 5.70% of estimated global GDP[4]. Turn the clock back ten years and only Microsoft featured as a top five global company[5]. On New Year’s Eve, Apple’s market capitalisation reached heights no company has achieved before, breaking the $1.3T mark. Looking forward to 2020 and the decade ahead, can we realistically expect these mammoths to continue to grow or could we see them stall or even become extinct?
While the tech industry is notably cyclical, the outperformance of big tech stocks can largely be attributed to the surprising promise they have shown at being able to adapt and innovate this year. Apple’s 2019 iPhone sales dipped in line with expectations; few users took the plunge to upgrade to the new model. However, this disappointment was outweighed by the potential of their wearable products that grew by 50% in the year to June[6]. Apple’s ability to successfully innovate away from its legacy product led analysts to factor substantial sales growth for the next few years into their valuation. Meanwhile Microsoft’s cloud services enticed investors, demonstrating year-on-year sales growth of 59% in its latest quarter[7], mirroring Apple in recent innovation progress. Finally, Facebook has so far managed to negotiate regulatory difficulties, shrugging off its dampened share price last year following the Cambridge Analytica scandal and gaining another 254 million users in the process[8].
At the turn of this year, evaluating FAAMG using a basic value metric, Market Value/Free Cash Flow (FCF)[9], highlights how expensive these stocks have become. A high figure suggests that in relation to other companies, the ratio of expected future FCFs to current FCFs is sizable and/or that these cash flows are seen as less risky.
As technology is a cyclical and risky sector, a significant proportion of the high prices of these stocks can be accredited to cash flow growth prospects. When considering that the majority of these stocks already generate significant cash flow in comparison to their sales, markets are already pricing in weighty sales growth for FAAMG stocks in the 2020s.
Based on these numbers, it is difficult to imagine FAAMG prices climbing much higher this year. Positive investment research tends to point to the opportunities in the services sector[10], such as Apple’s foray into TV production and Microsoft’s success in cloud provision. Services are seen as a more stable sector than technology, less susceptible to revenue fluctuations due to subscriptions and contracts. Lower risk in revenues would lead to further bolstered valuations. However, it is worth noting that these services are highly contested areas at the moment. Disney, Amazon, HBO and Netflix are all battling for viewer subscriptions and there is a war ongoing between Amazon’s AWS and Microsoft’s Azure cloud services. Progress in different services sectors for these giants is not a given and a win for one can often mean a loss for another. The current stock prices therefore continue to look hopeful and on the steep side.
For an outlook on the decade, it is worth noting how FAAMG companies appear to be bucking technology trends. The average technology company quickly blossoms, matures and withers as innovation surpasses them and their products become redundant. However, big tech companies are generally succeeding in branching out and diversifying their revenue streams, slowly transforming from technology companies into quasi-conglomerates. Their size allows them to stay at the forefront of demand, through massive databanks (which are proving to be barriers to entry for newcomers[11]) and big buying power for acquisitions. Damaging regulation, which has been a major concern for investors, has so far been avoided as a result of the global reach of FAAMG companies as well as their spending power; demonstrated by Facebook and its self-regulating investments following the Cambridge Analytica scandal. Further, diversification will lessen the damage of any potential future regulation. These forays into new technology and new sectors should keep big tech alive but will ultimately lead to more melees and increased competition as giants venture into similar products. Over the coming years, FAAMG growth is unlikely to reach levels anywhere near that experienced in the 2010s – any large big tech growth would most likely come from Asia where technology is starting to diverge due to nationalism. Nonetheless, these companies are here to stay and offer substantial exposures to the American and global economies that still hold the prospect of competitive returns.
[1] https://www.ft.com/content/5a6a95e6-e67e-11e9-b112-9624ec9edc59
[2] In terms of their market capitalisation – data from Bloomberg as of 10/01/2020
[3] https://www.jpmorgan.com/global/research/global-market-outlook-2020
https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US
[4] https://www.statista.com/statistics/268750/global-gross-domestic-product-gdp/
[5] http://media.ft.com/cms/419e021c-fecd-11de-91d7-00144feab49a.pdf
[7] https://www.barrons.com/articles/microsoft-stock-soared-in-2019-51578002778
[8] https://www.statista.com/statistics/264810/number-of-monthly-active-facebook-users-worldwide/
[9] Market Value/Free Cash Flow (FCF) is similar to a P/E ratio in its use but is more relevant to the factors that determine valuation and is less prone to manipulation. However, it can also be noted that current PE ratios make FAAMG stocks look expensive.
[10] J.P. Morgan, ‘Apple: Are Shares Expensive? Thoughts on What’s Priced in Already, and What Remains on the Table’, 06/01/2020
Deutsche Bank Research, ‘Microsoft: Pre-Quiet IR Catch-Up’, 16/12/2019
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
Our quarterly report presents our views on the world economic outlook and equity, fixed income and foreign exchange markets. Please click the link to download.
