The future of the FAANGs – time’s up or room to run?

Meta (Facebook), Amazon, Apple, Netflix and Google (Alphabet), better known as the FAANGs, have become known as the crème de la crème of the tech world. But that’s led to some uncertainty going forward.

With a combined market cap of $7.3tn, the fab five make up 18% of the S&P 500 – the largest 500 companies in the US. Boasting some of the loftiest price to earnings (PE) ratios on the market, it’s reasonable to question whether this upward trajectory can continue. Correct as at 4 November 2021.

Like many things in investing, it’s a subject for debate. But we think the FAANGs have more room to run.

This article isn’t personal advice or a recommendation to invest. All investments can fall as well as rise in value, so you could get back less than you invest. Remember, past performance isn’t a guide to future returns. If you’re not sure an investment is right for you, seek advice.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Adding growth to the equation

One of the strongest arguments against the FAANGs’ continued climb is they’ve become overpriced. Critics point to their ratios, which tells you how much investors are willing to pay for every pound of profit, as a sign the fab five’s nearing the end of its run.

Indeed, the FAANGs’ PE ratios are lofty, and that’s after coming down somewhat over the past few years. That’s especially true for Amazon, for which investors must be willing to pay $68 for each $1 worth of expected profits.

Source: Refinitiv, 04/11/21.

But the draw of the FAANGs has always been growth. Taking that into account using a price earnings to growth (PEG) ratio, which measures price against profits and profit growth, valuations across the board start to look a little more palatable.

Source: Refinitiv, 04/11/21.

Typically, a PEG close to one is considered desirable. From this angle, the price that Meta, Netflix and Alphabet command doesn’t look all that demanding. Apple’s PEG is on the higher end, but the group’s modest dividend makes its price tag look a bit more palatable. Remember though, dividends are variable and are not guaranteed.

Of course, there’s more to choosing investments than valuation, but it certainly offsets some of the worries about over-valuation.

Apple’s changing its core

Apple’s enjoyed impressive revenue growth since bringing the iPhone to market, and investors have become accustomed to sky-high growth.

Operating profits rose 64.4% over the past year. But to retain its seat at the high-growth table, Apple will need more than just the expensive gadgets it’s best known for.

Apple’s service arm, which includes subscription-based offerings like Apple Music and App development fees, aims to fill this void. The division currently makes up about 20% of overall revenue, which isn’t quite enough to move the needle. However, with gross margins nearly double that of the hardware business, it represents a very profitable growth opportunity.

If Apple’s to remain a hot growth stock, we suspect this part of its business will need to become a larger focus.

Apple Full Year Revenue Breakdown ($m)

Source: Company accounts 28/10/21.

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The ethical cost of growth

Meta and Google come with plenty of growth opportunities. The two own some of the most valuable internet real estate out there. But they’re both plagued with regulatory concerns that could ultimately cap their potential.

Both are at the centre of an ongoing debate over whether or not their dominant market position should be regulated. Many have called for utility-like rules that would disrupt the way the two do business. This is a significant risk, but it’s one that’s been lingering for years without much movement.

Like Apple, there are questions about where they’ll go from here. In Meta’s case there’s plenty of room to run – the group owns four of the top six most downloaded apps on the planet, and has only just began to monetize some of them.

2020 app downloads (millions)

Source: Apptopia, mint bars represent Meta ownership.

Alphabet’s growth runway lies in Google Cloud and a handful of “Moon shoots”, including self-driving cars and tech-heavy healthcare offerings. Trouble is, the moon-shoots are expensive to finance and are nowhere near bearing fruit. Google Cloud is getting closer to being in the black, but still represents a drag on profitability for now.

The good news is Alphabet’s impressive ad revenue growth is more than enough to fund these projects and placate shareholders. But all of that could change if regulators pick apart the group’s business.

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Netflix can’t chill

That brings us to Netflix.

Netflix practically invented the streaming business, and that’s given it a distinct advantage over rivals – it seems once people get hooked on Netflix content, it’s hard to give up. But it’s not yet clear whether those who came on board during the pandemic will be as sticky as long-term Netflix fans.

Netflix subscriber growth

Source: Netflix 2020 annual report.

Content is king among the streamers, and it’s expensive to create. Netflix spent well over $11bn on content last year, which was covered by incoming cash for the first time. However, a post-pandemic subscriber exodus would be a shock to the system.

To avoid a plateau, the group needs to spread its wings beyond box-sets and films and it’s doing that by expanding into gaming. Netflix hopes diversifying its content offering will make it easier to raise prices, a necessary lever as subscriber growth becomes harder to achieve.

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You get what you pay for

Amazon is the most expensive of the FAANGs by virtually every metric. The lion’s share of revenue comes from the group’s namesake e-commerce business, but profits are another story. In the third quarter AWS, Amazon's computing arm, was responsible for all of Amazon’s operating profits, but just 15% of revenue.

Amazon Third Quarter Revenue Breakdown (millions)

Source: Amazon company accounts, 28/10/21.

It’s this high-margin part of the business that growth investors are excited about. The cloud computing market is expected to grow at a compound annual rate of 19.1% over the next seven years, and Amazon commands over 40% of that market.

There’s no guarantee that will continue, though – competitors like Microsoft, Google and Alibaba are nipping at Amazon’s heels.

Still Microsoft, the next largest provider, serves just under 20% of the market. We suspect cloud computing will end up being a business where size matters, and on that front, Amazon has a head start.

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Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure on our website for more information.

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