Lately, a lot of the stock market hype has centered around the FAANG tech stocks. These include Facebook, Amazon, Apple, Netflix and Google. These companies have been hot performers; it seems that everyone and their grandmother is either buying these stocks, touting their performance, or recommending to “buy the dip” after any selloff. When asked which stocks to buy, most investors would probably mention these high-flying stocks, citing the 50%+ gains just this year and the tremendous rise over years past. I sit on the opposite side of these investors. If you want to play in the casino, then load up on these stocks, notably Amazon and Netflix. I think investors in these stocks, aside from Apple, are in for a rough ride over the next few years.
A Brief Reminder of the Dot Com Bubble
Back in the late 1990’s, the market experienced a huge boom riding on the potential of the Internet’s impact in business. I was only just born during this time, but there is an endless amount of information available to learn about this classic boom and bust. For several years it seemed like Internet stocks were going to go up forever. Companies that weren’t making money, or revenues in some cases, were selling at ultra-rich valuations just because their future would be driven by a new technology. Eventually, the asset prices were bid so high that there were not enough suckers to keep bidding, the smart money had bailed, and there was a historic collapse in values for tech stocks.
The speculative, gambling-like attitude was driven by a euphoric belief in a new concept that has a bright future. People were making money hand over fist, and no one wanted the party to end. Contrarians were shunned. Traditional methods of valuing assets were thrown out the window.
I’m afraid we are experiencing something similar with some members of the FAANG stocks. Let’s use Amazon as an example.
Amazon has been the early leader of online shopping and home delivery. They’ve put competitors out of business and grown market share in several different categories. The disruptive concept has made investors a lot of money. The stock has risen over 76-fold in the past 10 years. I don’t doubt that their concept has a promising future. What I do doubt is the stock’s price in relation to its value.
All sound investing relies on an attention to price and value. What makes sense at one price does not at another, based upon the value the investor receives. All else equal, if one asset produces $2 of income and costs $10, while another produces $1 of income and costs the same $10, any investor that is trying to make money will choose the former. The story changes when there is future growth to be estimated and different levels of certainty to the income, both of which can change the value of an investment to prospective buyers. That’s where the game gets tricky and excess gains or losses can happen.
In the case of Amazon, we have a new and disruptive concept that has made stockholders rich. Everyone is talking about the stock because it’s been on a tear with more to come. Its future in business has no limit. People love the concept, growth is outstanding, and there are more avenues yet to be conquered. Bezos went from an outcast to the richest man alive. The story is compelling.
Back to the Internet in 1999. It was a new and disruptive technology that was making people rich. People were buying Internet stocks because their neighbor was boasting about their returns in the market. Its future in business had no limit. People loved the concept, expected growth was off the charts, and every field would soon use the Internet.
The eerily familiar euphoric attitude has once again caused certain valuations to become very high and less attached to the fundamentals of the asset itself. Market participants are speculating over stratospheric future growth (key valuation criteria) over a long period of time, which cannot be estimated or measured with a very high degree of certainty (key valuation criteria). The numbers tell the story.
Can you see the future?
I’m going to show you that Apple’s stock provides much more value than Amazons does because the certainty factor outweighs the growth factor in this valuation. The most simple metric I can give you is the fact that Apple makes nearly 10 times more money than Amazon, and is growing strong, yet Amazon is valued at about 90% of Apple’s total value and just recently they were valued almost identically. Such a thing is difficult to rationalize, and I’d say its illogical. If that’s not enough to convince you, read on.
The Price to Earnings multiple (PE) is an elementary method to determining how expensive an asset is. I’ll provide a brief explanation. It tends to be higher when there is greater potential for growth or if the income produced by the asset is more certain. An average PE is around 17. A cheap one may be considered 8, and an expensive one would be above 25. The reciprocal of the PE also gives us our earnings yield, which is essentially the stock’s underlying income return on the stock price. A 25 PE is a 4% earnings yield. A 10 PE is a 10% earnings yield. Ideally you want a higher earnings yield, but many people accept a lower one if there is expected growth in the earnings. Growth will take the stock price higher, along with a higher certainty of future earnings, granted that these developments weren’t already priced into expectations with a high PE multiple.
Let’s compare Apple to Amazon. Here are the numbers, with the earnings from the last 12 months.
| Apple | Amazon | |
| Price/share | $207.99 | $1,823.29 |
| Earnings per Share (EPS) | $11.06 | $12.62 |
| PE | 18.8 | 144.5 |
| Earnings Yield | 5.32% | 0.69% |
By buying Apple stock, you are certain to get a current yield over 7 times greater than Amazon’s right off the bat. But many expect Amazon to grow faster, so that is worth more when compared to Apple’s growth. So just how fast would Amazon have to grow to catch up to Apple’s yield? Remember Apple is growing, too, and at a strong rate. Let’s give Apple an average 8% growth rate for 10 years, assuming some years of great growth and some with none, like years past. We are looking for the 10 year earnings yield on our original cost for the stock.
| Cost Today | Year 1 EPS | Year 3 EPS | Year 5 EPS | Year 10 EPS | Year 10 Yield on Cost |
| $207.99 | $11.94 | $13.93 | $16.25 | $23.88 | 11.48% |
Not a bad showing from Apple, but nothing spectacular. We can use this information to see what type of growth we would need from Amazon to match the 10 year Yield on Cost from Apple, which is an estimated 11.48%. At Amazon’s current price, $1,829.23, they would need to earn $209.31 per share in 10 years to match the yield. Compare this to the current earnings per share of $12.62 and you can see that Team Bezos has their work cut out for them. They will have to increase their EPS over 16-fold in 10 years, only to match a reasonable yield from Apple 10 years from now. With this info, we can find the growth rate required.
To match Apple’s 10 year expected yield on cost, Amazon would have to compound its earnings at 32.43% a year for 10 straight years. This feat is tremendously difficult to do in business. One may equate this growth record to that of an MLB player batting .350 for 10 years in a row. Don’t forget Amazon will also be weighed down by its size, as a larger revenue base becomes more difficult to grow. This can be compared to how MLB pitchers adjust their scouting report to utilize the best way to pitch to the .350 hitter. Each year it will only get harder to meet the mark. And meeting the mark is basically what is already expected of Amazon (growth is priced in), so they must grow faster than 32.43% to deliver excess returns for investors.
I’ll simplify all this information. You are being given the same betting odds for the following two bets: 1) Apple grows its EPS at 8% for 10 years or 2) Amazon grows its EPS at 32.43% for 10 years. Your yield, or bet payoff, in 10 years is the same in each situation. If you bet based on favorable probability, I think the Apple scenario is a much more likely outcome. The Apple bet also has more upside, as 8% growth is much easier to top than 32.43% growth. Such an extended and high rate of growth would be truly remarkable, not something that I would consider even close to a certainty or that I want to put my money on.
So how can people say with such certainty that Amazon will be able to grow that fast and that far into the future to the point that it makes sense to pay 144.5 times the current earnings? I can’t even be certain that Apple will grow at 8%, but when I look at probabilities I feel fine betting on that. I also get a much higher earnings yield on my money in the present that I can see returns on through dividends or buybacks.
The picture gets even more ridiculous when you compare a company like Walgreens, who has a great history and a stock I recommend as a buy, to Amazon’s hot friend, Netflix. Just last month, Walgreens sold at a 10% earnings yield. Even after its recent price drop, Netflix is selling at a whopping 0.64% earnings yield. Let’s assume Walgreens can only grow at about inflation, a conservative 3%. To catch up to Walgreens’ yield in 10 years, Netflix would have to grow earnings at 35.34% for 10 years straight. And that’s assuming a company like Walgreens will only grow at inflation over 10 years, which is an outcome one could assign as fairly likely based on the past. Again, which outcome do you want to bet on for the same payoff? I’ll bet on Walgreens to grow at inflation instead of praying Netflix can pump out year after year of rarely achieved growth rates. And there’s a big downside if they don’t.
It all comes down to what you want to bet on. With Apple, you can be wrong about future growth and at worst you have a 5.32% yield and probably a manageable capital loss. Walgreens is an even safer bet. With some of the other FANG stocks, if you are wrong about future growth, you may experience a severe capital loss. I would like to bet against the high flyers, but I’m not sure I can stay solvent for as long as the market can remain irrational. There is no telling how much higher the FANGs can go before reverting.
Be Cautious
Today’s buyers of the FANG stocks are paying a steep price for growth that has not yet happened, and will not be known for quite some time. Business in general is very hard to predict, and relying on high growth outcomes that are 10 years into the future is speculating. That’s why I look for a margin of safety, which is what the company is earning presently in relation to the price. In that regard, Amazon and Netflix are very risky investments when compared to stocks I’ve been buying, like Apple and Walgreens. I predict that buyers of Amazon and Netflix will get burned. You should have a strong analytical insight into the company’s future economics in order to justify a sound investment at current prices. Even if growth is a strong 20% a year, the stock could under perform over the next 5-10 years just because of the expected growth already reflected in the stock price. If valuations revert to a more realistic level, assessing growth and certainty, then it may take quite some time for investors to recoup their original investment.
Maybe then I will consider them as investments, when the euphoria has subsided and those great growth companies are on sale, rather than at these sky high valuations. Don’t get me wrong, either. They are all impressive businesses, but we must remember that what makes sense at one price does not make sense at another.
BJD
BD Capital 