Proinsias O’Mahony: History says the top dogs do not reign forever

Facebook, Amazon, Apple, Netflix, Google – the soaring share prices of the so-called FAANG stocks have driven the US stock market to multiple all-time highs in 2017. With valuations now at heady levels, has this select group of super-stocks become too fashionable for its own good? The FAANGs are enjoying a stellar year. Facebook and Netflix have risen almost 50 per cent; Amazon and Apple by over 30 per cent; Google (or Alphabet, as it is officially known) is the laggard, although its 20 per cent rise is roughly twice that of the S&P 500.

Extremely rapid gains are rarely seen in such large companies – Apple, Google, Facebook, and Amazon are four of the five most valuable companies in the US (fellow tech stock Microsoft also makes the top-five list), all recently sporting valuations of $500 billion or more.

All have massively outperformed stock markets over the last five years, so much so even fans of the collective agree they’re not cheap. The market values the FAANGs at some $2.5 trillion, or over 30 times their combined earnings. Although the stocks appear pricey, few expect the party to end any time soon. Short sellers – traders that aim to profit by betting on stock price declines – are steering clear: if one excludes Netflix, short bets account for just 1 per cent of traded shares, barely a quarter of the short interest for the S&P 500 as a whole.

A recent Merrill Lynch fund manager survey found 71 per cent were overweighting the tech high-fliers relative to the rest of the market.

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Although Amazon, in particular, appears dangerously expensive – it trades at over 200 times trailing earnings – analysts are relaxed. Barclays, for instance, says Amazon becoming a trillion-dollar company is “just a question of when, and not if”; 20 out of 29 analysts covering the stock rate it as a strong buy; just one has a sell rating. The reason for this enthusiasm is the FAANGs are essentially regarded as bulletproof growth companies whose excellent prospects overrides valuation concerns.

Captured the future

"They all sport great business models and unchallenged leadership in their markets", wrote billionaire money manager Howard Marks in a recent Oaktree Capital client letter. "They're viewed as having captured the future, and thus as sure to be winners in the years to come". Marks, a value investor who predicted the dotcom and banking crashes in 2000 and 2007 respectively, says some scepticism is required. The current adulation, he says, mirrors that accorded to technology stocks in the late 1990s, disk drive companies in the 1980s, oil stocks in the 1970s and the so-called Nifty Fifty in the 1960s. Comparisons with the dotcom era may seem harsh, given the FAANGs are genuinely strong companies that bear little resemblance to the tech stocks of old, but many see the Nifty Fifty comparison as apt.

The Nifty Fifty was a term used to describe a famous group of “can’t-lose” growth stocks in the late 1960s. The companies, which included names like Coca-Cola and IBM as well as Polaroid, McDonald’s, and Xerox, were labelled “one-decision” stocks because you only needed to buy them but would never need to sell them.

“Each one was a corporate icon, or what I call a ‘head nodder’,” Marks wrote in a 2007 client letter – “one person says ‘Xerox’ and everyone else nods and says ‘great company’.”

The problem with such adulation is it leads to excessive valuations.

By 1972, some of the group were trading on 80 or 90 times earnings, setting the scene for carnage when stocks crashed in the 1973-74 bear market. Stocks like Kodak, Polaroid, Xerox, and Sears were ultimately hobbled by industry changes, whereas even the long-term survivors endured massive drawdowns courtesy of being priced for perfection. “The FAANGs are truly great companies, growing rapidly and trouncing the competition,” says Marks, but the prices investors are paying represent more than 30 years of their current earnings. Are they really invincible, asks Marks, “and is their success truly inevitable?”

Infancy

Technology investors cannot see the future, he argues. Ten years ago the iPhone didn’t exist. Twenty years ago the internet was in its infancy.

In Amazon’s 1997 report, notes Marks, the company referred to its “long-term relationships with many important strategic partners, including America Online, Yahoo!, Excite, Netscape, GeoCities, AltaVista, @Home, and Prodigy”.

In the same year, notes Ben Carlson of Ritholtz Wealth Management, Apple needed to be rescued with a $150 million loan from Microsoft, and Michael Dell said Apple should shut itself down and return its remaining money to shareholders.

Facebook didn’t exist until 2004, adds Carlson, when it was founded in a college dorm room. Carlson’s data backs up Marks’ contention that no group is likely to continue outperforming ad infinitum.

Going back to 1980, he looked at the top 10 most valuable US stocks at year-end. Every five years an average of 4.5 new companies enter the top 10. Citigroup and AIG were among the top 10 most valuable US stocks in 2000 and 2005, but shareholders lost most of their stakes over the last decade.

Other fallen giants include Sears (currently in a battle to avoid bankruptcy), Eastman Kodak, General Motors, America Online, and Bank of America. Apple, Amazon, Facebook and Google may continue to outperform, of course, but that would be bucking the historical trend.

Between 1972 and 2013, the S&P 500 gained approximately 5,000 per cent, according to Ned Davis Research, whereas your portfolio would have only gained around 400 per cent if you’d owned the biggest stock in the index every year. Why?

“By the time a stock is No 1 in the market nearly everyone owns it, and the story is well known”, said Ned Davis Research, the message being that “popularity kills”.

Research Affiliates money manager Rob Arnott calls this the “winner’s curse” – the tendency for the biggest companies to ultimately underperform over the following years. Arnott’s research shows this to be a global and long-running phenomenon. The risk of underperformance among today’s big guns seems especially marked given current valuations. Apple appears relatively inexpensive – it trades on 18 times trailing earnings (less if one accounts for its enormous cash pile of over $250bn). However, Facebook trades on 44 times trailing earnings; Google trades on 34 times earnings; Amazon trades on over 200 times earnings.

Simplistic

Bulls see such valuation metrics are simplistic, and note that doubters were saying the same thing five years ago, during which time the share prices continued to rocket.

Simplistic or not, such valuation multiples are associated more with start-up growth companies rather than with companies in the $500 billion club, indicating an awful lot of good news is already baked into current prices. Investors feel the FAANGs “can do no wrong right now”, says Carlson, but history says the top dogs do not reign forever. That caution is echoed by Howard Marks.

Human nature means the best companies eventually get to be overpriced, meaning share price performance becomes ordinary even if the fundamentals hold up. And if the FAANGs turn out not to have been the best companies, or if their business unexpectedly falters, then a “really painful” experience awaits shareholders.