FAANG is one of the most important stories in the stock market. These companies – Facebook (Nasdaq: FB), Apple (Nasdaq: AAPL), Amazon.com (Nasdaq: AMZN), Netflix (Nasdaq: NFLX) and Alphabet (Nasdaq: GOOGL) (parent of Google) – have been drivers of the stock market for the past few years.
This presents a potential problem. This small group of stocks now represents a large part of the stock market. They make up nearly 40% of the Nasdaq 100 index and a large share of other broad indexes as well.
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In the past, when one group of stocks becomes a large part of the market indexes, that has been a sign of impending decline. For example, finance stocks became a large part of the stock market in 2007 and Internet stocks made up a large and larger share of the market in 1999.
There are reasons that narrowness in the market precedes a decline.
Innovators Become Less Innovative
The stock market is, in many ways, an economic indicator. A rising stock market is associated with a growing economy and a declining market tends to be associated with a contracting economy. In many ways, innovations drive the expansion of the economy and a rising stock market.
There is no question the FAANG stocks have been leading innovators.
Facebook, for example, is widely recognized as a news and content platform. In fact, according to news reports, “Hillary Clinton is apparently willing to swap a life in politics to lead the world’s largest social-networking company.
The 2016 presidential candidate was at Harvard on Friday receiving the Radcliffe Medal, which honors people who’ve “had a transformative impact on society.” Attorney General Maura Healey, a democrat from Massachusetts, asked Clinton which company she’d want to be the CEO of.
Clinton didn’t pause before quickly answering “Facebook.”
“It’s the biggest news platform in the world,” she said. “Most people in our country get their news — true or not — from Facebook.””
Apple created the iPhone, the app and changed communications technology. Amazon changed the retail experience, in the physical and online worlds. Netflix changed the world of entertainment and Google changed every day life in many ways.
These innovations explain why the shares of the stocks have done so well over time. Investors are buying the stocks because the companies are generally large and profitable with increasing market shares.
But, history shows that large companies tend to drive away competition. The next iPhone, for example, is now likely to come from iPhone and competing with Facebook will be difficult, if not impossible, for new startups. That decreases innovation in the economy and could lead to slower growth for the giants.
Although it is likely the FAANG stocks could continue to receive more and more revenue from the goods and services they provide, it is unlikely they will be able to grow as rapidly as they did in the past. That makes it important to consider valuation when investing in these companies.
Valuation of FAANGs Is Increasingly Important
While these companies have grown quickly, the current value of the stock is largely a bet on the future rate of growth. High prices will require high growth to be justified. Valuation tools can help investors decide whether the stocks should be considered buys at their current prices.
The table below summarizes several popular valuation metrics for each of these companies. The price to earnings (P/E) ratio is shown along with the price to book (P/B) ratio and the price to sales (P/S) ratio. As a benchmark, the same ratios for the S&P 500 index are also included in the table.
From that table, it is clear that all of the stocks are priced above the market averages. This indicates the FAANG stocks are unlikely to continue delivering the pace of stock market returns that they have in the past.
Bulls will argue that the stocks have always been richly valued. And they would be correct. The next chart shows the historic P/E ratio of AAPL.
Source: Standard & Poor’s
However, the high valuations were in a period of declining interest rates. In fact, the high valuations were in a period of time when interest rates were at historic lows. That is no longer the case. The Federal Reserve is reversing course and interest rates are rising.
In a rising rate environment, the valuation of the stock market is expected to decline. This should result in lower P/E ratios and other valuation metrics should show the same trend. This could lead to lower stock prices.
In addition to interest rates, the narrowness of the stock market, the large percentage of capitalization that these five stocks represent, also points to a slowdown in gains. There is simply no reason to expect their growth to continue at rapid rates now that they are so large.
Index funds will continue to be buyers of these stocks but value investors may decrease their exposure. These are still great companies and value investors are likely to return to buying after a decline occurs. The decline could be in valuation rather than price if the stocks consolidate for some time.
Now, operationally, no company appears to be in a position to challenge these market leaders in the near term. However, investment wise, there could be better opportunities for investors in less widely owned stocks.
In the future, FAANG stocks could be profitable, but it is important to research the industry because of its risks.
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