A lot has been written about FAANGs in recent times. These fast-growth companies have outperformed their industry peers and the broader market in recent years as their market capitalisations have soared. They’ve led mega-caps to outperform and masked much of the markets’ low breadth rise. These stocks are widely held in many institutional portfolios, whether they are active or passive funds. Many managers hold all or a combination of these stocks, which has raised concern over valuation risk. But are FAANGs as overvalued as investors fear? What is their level of outperformance over the last few years? What are the fundamentals behind these stocks? To analyse these issues we used a portfolio approach to assess the fundamentals behind an equally weighted portfolio of FAANGs and discuss our findings in the following sections.
FAANG is an acronym for the five most popular and best performing tech stocks in the market, namely Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG). Wall Street grouped these entities into one acronym to capture the collective influence they have on the markets. These fast-growth companies have outperformed their industry peers and the broader market in recent years as their market capitalisations have soared. They’ve lead mega-caps to outperform and masked much of the markets’ low breadth rise. These stocks are widely held in many institutional portfolios, whether they are active or passive funds. Many managers hold all or a combination of these stocks, which has raised concern over valuation risk. But are FAANGs as overvalued as investors fear? To analyse this, we take a portfolio approach and assess the fundamentals behind an equally weighted portfolio of FAANGs.
As of 31st July 2017, the market capitalisation of these companies summed up to A$3.08 trillion, which is twice the size of the Australian economy at A$1.6 trillion (ABS, 31.3.17).
Source: Morningstar Direct, Foresight Digital
Approach is equally weighted portfolio of FAANGs
We examine these questions using a portfolio-based approach. We created an equally-weighted portfolio of the FAANGs and benchmarked it to both S&P500 and MSCI ACWI Indices. We used 5 years of holdings data (May 2012-July 2017), a period that was limited by Facebook’s listing approximately 5 years ago.
Our diagnostics process assessed the fundamental, risk and return behavior of the FAANGs.
Performance is not thematically driven
Over the past five years, FAANGs have outperformed the MSCI ACWI index (a proxy for global equity markets) by 38 percent per annum. This level of outperformance needs to be placed in a context as the active share of the equally-weighted FAANG portfolio was 96 percent and tracking error of 18 percent.
Importantly, this source of outperformance has been less correlated with style and other systemic factors than we expected. In other words, company specific drivers have been the key source of outperformance for the FAANG based on factor-related attribution. This is an important point as many have suggested that the outperformance of FAANG stocks is thematically driven.
Risk is not thematically driven
A multi-factor based risk model breaks down risk into systemic (example style, sector, currency) and idiosyncratic components. Our analysis shows that the FAANG portfolio has been predominantly driven by idiosyncratic or stock specific risk drivers, on average accounting for approximately 75 percent of active risk relative to the world market index. The systematic components explained approximately 25 percent of the relative risk – sector risk contributed 8 percent, currency 3.5 percent, style 3 percent, and market risk 3 percent. Overall, the evidence from our global risk model suggests these stocks have been less about thematic and more about a stock-specific story which is contrary to the popular commentary.
Fundamental factors are growth-oriented
Fundamental factor diagnostics show that the FAANG portfolio is growth-oriented with large cap growth being the dominant style. These fundamental drivers (both historical and prospective) suggests that investors have been attracted to these names based on earnings growth, sales growth, long term sales growth, asset growth, 12 month forward earnings and sales growth drivers. Momentum is also a statistically significant factor reflected in the FAANG portfolio.
Historical Factors – short term
Historical and Forward Factors – Longer term
Examining the longer term fundamental factors such as the cyclically adjusted price earnings yield (CAPE), the FAANGs portfolio appears more expensive than the market. This overvaluation is approximately two standard deviations away from the market which in our opinion does not resemble bubble-like valuations. Over time, CAPE has been relatively stable and certainly not becoming more expensive for these stocks. The longer term expected growth appears strong relative to the market from capital expenditure growth, long-term earnings growth and long-term sales growth perspectives.
Longer term volatility is higher than the market, probably reflecting greater uncertainty around the growth prospects and intrinsic valuation of the FAANGs. Longer term momentum factor is also high which is expected of a portfolio that has significantly outperformed the broad indices and its industry competitors.
To sum up
The expensive valuation and spectacular performance of the FAANGs have been compared to that of the technology stocks before the 2000 dotcom burst, which saw a lot of overvalued company market capitalisation collapse. However, some analysts and institutional investors have argued that there is a difference between both tech classes, stating that there is plenty of room for the FAANGs to grow in new and emerging areas such as cloud computing, social media, e-commerce, Artificial Intelligence (AI), machine learning, and big data analytics. Certainly, based on our analyses of the FAANGs using a portfolio-based approach, these stocks in aggregate look expensive and we can understand why many conservative and value-oriented investors have avoided these names. However, the valuations don’t look outrageous even when using long term valuation tools such as CAPE. Further, the growth attributes both (historical and forward) have been much stronger than the market and their industry sector.
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