Might FAANGs take a bite out of your portfolio?

investment insights

Might FAANGs take a bite out of your portfolio?



Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

Stéphane Monier

Chief Investment Officer
Lombard Odier Private Bank

Since 2013 the technology sector has accounted for a rising share of stock indices, and this year returns have outstripped the wider market. As the importance of tech companies has risen from 17% to 26% of the MSCI World since the financial crisis, we look at the risks and opportunities the sector presents for investors’ portfolios.

Rising importance of the technology sector

In the year to date, the S&P500 has returned 1.85% while the information technology sub-index, led by so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google’s parent Alphabet), has posted an increase of more than 10%. The sobering thought for investors in market cap weighted indices is that, without FAANGs, the S&P500’s year-to-date performance would have been -0.19%1.

On valuations, the forward price-earnings (P/E) ratio for the S&P500 technology sector is 18.9 times estimated earnings over the next 12 months, compared with 16.5 times for the index as a whole and a far-from-scary level compared with the last decade. That’s close to 2007/2008 levels but nowhere near the 51 times price-to-earnings ratio seen before the tech bubble burst in March 2000.

It is worth revisiting the tech bubble for a moment. Balance sheets today are far healthier than 18 years ago when the tech sector accounted for 32.9% of the S&P500’s market cap (and 33.4% of the MSCI) at its peak. In March 2000, tech stocks offered investors an operating margin of just 14%, compared with 27% today and tech companies now hold 11% of their market capitalisation in cash, compared with 2.5% in 2000, and free cash flow yield is four times higher today at a healthy 4.5%.

While some investors consider large-cap FAANG stocks a haven from volatility, the wider sector’s diversity provides the real benefit to investors. Each segment and sub-segment offers different growth characteristics and decoupled valuations providing investment managers opportunities to unearth value.

What are the key dangers for tech, beyond a slow creep towards overheated valuations? Clearly, there is the rising cost of regulatory demands, as well as the permanent threat of hacking or data mismanagement. While not necessarily posing an existential threat, such incidents can damage sentiment, both at the consumer and investor level. Look for example at Facebook’s near 20% dive following headlines about its links with Cambridge Analytica’s politically motivated data scraping. In the short-term, the case pushed Facebook to commit to employing 5,000 more security and content-monitoring staff.

In the meantime, technology companies are beginning to compete in each other’s markets. Amazon for example has moved into Google and Facebook territory in the search for advertising revenue, while Google and Tesla are both in the race to develop reliable autonomous vehicles, and Apple TV is trying to compete with Netflix. As giant tech firms sprawl into rivals’ markets, margin pressures can only increase.

Tariff threats from the US have directly affected the sector recently, leading on 25 June to a sell-off, particularly in semiconductor makers exposed to China. Nevertheless, technology supply chains are deeply interlinked and we believe that the political posturing around trade will be resolved before there is any lasting damage to the prospects for economic growth in the US, China and beyond.

China is big enough to be a tech story all of its own. It currently accounts for around one-third of the tech market, and over the longer term, there is still plenty of room for growth in both China’s domestic consumer tech market and its global ambitions. According to the latest figures from the World Bank, the country has seen extraordinary growth in the percentage of the population using the internet, from about 8% in 2005 to just over 50% in 2016. That still sharply lags the US’ 76% and the UK at 95%, providing some measure of potential growth2.

Technology’s subsectors are already splitting to provide differentiated performance for software and services (the highest performing sub-set, information technology, semi-conductors and equipment and hardware). We may also see investors differentiate between technology users and technology developers within the sector. After all, while Netflix uses the internet to distribute content, the company is not building new technologies to stream movies. No-one insists that an airline is a tech firm simply because you buy seats online.

Historically investors have favoured consumer staples to ride through an economic downturn.  As innovation matures, technology companies are so deeply embedded in our lives that they more closely resemble a traditional return on capital investment than a bet on growth. Think of a product such as Apple’s iPhone, which consumers now see as staple in its own right.

The evolution of the internet has gone through three phases of innovation. Starting with a focus on content it then delivered services, followed by the rise of social media companies and interaction between people. In the next stage, the so-called “internet-of-things” will see machines learn to talk to one another and artificial intelligence increasingly intervene between people and their wider world, opening new avenues of growth for the most nimble firms and investors.

1 Source: Ned Davis Research, data as of 29 June 2018
2 https://data.worldbank.org/indicator/IT.NET.USER.ZS?end=2016&locations=CN-US-GB&start=2001&view=chart

 

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