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Vitaliy Katsenelson
Vitaliy Katsenelson
Articles (232)  | Author's Website |

Nifty FAANG and Other 'One Decision' Investment Strategies

Looking at the stock market today, the first thought that comes to mind is that it is divorced from economic reality

If in early January, youd have described to us everything that was to happen with the world and global economy and then asked us to guess where the stock market would be, we would not have guessed it would be at todays level.

Looking at the stock market today, the first thought that comes to mind is that it is divorced from economic reality. The S&P 500 is only a few percent away from where it started 2020.

On the surface it looks like stocks discount one incredibly rosy version of the future. In that version everything goes back to normal like nothing happened; we basically just entered and quickly exited a sharp recession and earnings came back to pre-coronavirus normal. Though that is a possible outcome, it is not a probable one, judging by what is happening right now. Wed like to note that, in any scenario, well exit with close to $10 trillion of additional debt on the governments and the Feds balance sheets

I used the word discount. To discount something you bring future earnings (cash flows) at a discount rate to todays dollars. The Federal Reserve bought trillions of dollars of U.S. Treasuries and corporate bonds of suspect quality through ETFs, taking interest rates to almost zero. This act has pushed the discount rate lower and wound up the spring of the music box in the Feds game of musical chairs. So the market behavior to a large degree reflects not the sum of future scenarios but the much lower discount rate by which these scenarios are discounted.

Since the Fed is buying, the music is playing, and investors keep dancing (speculating). Greed is back. It seems that this music just keeps on playing.

But will it?

The economy is a very complex organic system created by trillions of individual transactions. The Feds involvement introduces inorganic matter into the ecosystem that slowly poisons and atrophies the system. The Feds active involvement distorts price signaling (higher prices lead to higher demand and vice versa) as it manipulates the price of the most fundamental commodity in the system interest rates (the price of money).

The Feds buying junk bonds through ETFs has brought us closer to a Walking Dead economy. It has given a further lease on life to mostly dead companies that otherwise would have perished. But its easy for me to sit here and criticize. If I ran the Fed in March 2020, I probably would have done the same thing the possible cost of doing nothing would have been a global depression. The bottom line is that the Fed temporarily stimulated a humongous amount of greed in a system that was shaking in fear.

We are not investing in the economy wed like to have, but in the one we have. However, this dance cannot go on forever or at some point the Fed will own all financial assets and the U.S. economy will turn into a Potemkin village. This is why, though it has been unfashionable and even counterproductive lately, well keep sticking to buying great, undervalued companies, not just great companies irrespective of price.

Nifty FANGAM

While you are pondering on this, here is another observation.

If you look deeper under the hood of the stock market, youll see that there is a significant dichotomy between bytes stocks and atoms stocks. The atoms are losing to the bytes, badly. If you compare performance of the S&P 500 (SPY) traditional market-capitalization index the one you see in the news to its less-known cousin, the S&P 500 equal-weighted (RSP), youll see a significant disparity in performance.

In the market cap-weighted version, the top five stocks (all five are members of FANGAM gang Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOGL), Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT)) now represent 21% of the capitalization of the index (the last time this happened was 1999) and thus account for 21% of the returns. In RSP these stocks have a weight of 1% (theyre just 5 out of 500 stocks).

SPY is down 6% for the year, where RSP is down 16% remember, same stocks, its just that SPY is heavily weighted toward bytes stocks, as they have larger market caps, and RSP treats bytes and atoms equally. The virus has been much kinder to bytes than atoms stocks; it has benefitted those companies as our world has become a bit more virtual and atoms were impacted by social distancing. The problem is, bytes were very expensive going into the coronavirus crisis, and they just got even more pricey (unless their businesses have improved to a greater degree than their stocks prices appreciated, which is possible but unlikely, with the possible exception of Amazon).

Just as any propaganda needs a certain germ of truth to grow from, so do bubbles. The FANGAM are incredible companies (germ of truth), and they function better in the virus-infested world (another germ of truth). But at the core, their existence is grounded in the world that is built of atoms, not bytes.

For instance, Googles advertising business will continue to take market share from non-digital forms of advertisement (not sure if any are left), but atom-based companies are the largest source of Googles advertising revenue. If the atom world is not doing well, neither will Google. Also, the law of large numbers usually kicks in at some point: A company cannot grow at supernormal rates forever or it will become bigger than the market it is serving.

The Nifty Fifty stocks come to mind here. Those were the fifty stocks the whos who of the 1960s that made America great (then): Coca Cola (NYSE:KO), Disney (NYSE:DIS), IBM (NYSE:IBM), Philip Morris (NYSE:PM), McDonald's (MCD), Procter & Gamble (PG) the list goes on. Though today we look at some of them as has-beens, in the 60s and 70s the world was their oyster. Coke and McDonald's were spring chickens then, spreading the American health values of diabetes and cholesterol (okay, maybe Im being too hard on them) across this awesome planet.

Although it was hard to imagine in the 70s that any of these companies would not shine forever, they are a useful reminder that even great companies get disrupted. Avon (AVP), Kodak (KODK), Polaroid, GE (GE), Xerox (XRX) all were Nifty Fifties, and all either went bankrupt or are heading towards irrelevancy.

In the 1960s and early 1970s these stocks were one-rule stock and the rule was, buy! They were bought, and bought, and bought. They were great companies and paying attention to how much you paid for them was irrelevant.

Until.

The Nifty FANGAM is arguably not as expensive as the Nifty Fifty was in 1972. Lawrence Hamtil put this nice table together, using data gathered by The Brooklyn Investor blog, which divides the Nifty Fifty stocks into two groups. The cheap basket traded at around 28 times earnings and the expensive basket at about 60 or so. Neither the cheap nor the expensive basket did well in the decade of the 70s. Today, FANGAM stocks in general trade closer to the cheap baskets valuation.

If you bought and held Coke or McDonald's in 1972 (or any other Nifty Fifty stock), then you experienced a painful decade of no returns; in fact, at times you were down 50% or more. Coca Cola was as great a company in 1974 as it was in 1972, but the stock was down 50% from its high. Okay, Coca Cola was trading at 47 times earnings in 1972. But even a company like Procter & Gamble that was trading at only 32 times earnings in 1972 was down almost 50% in 1974 from its 1972 high. It took until the early 80s a decade until investors who bought Nifty Fifties at the top broke even and this applies to almost all of them.

Nifty Fifty (1970s)

In todays far less patient world, that decade might as well be infinity.

As I am writing this I am struggling with a few issues. First, interest rates and inflation were much higher in the 70s and early 80s. Now, interest rates are at zero, going to negative or to no idea what level. Globalization was deflationary, thus de-globalization will likely be inflationary; but automation may dampen the inflationary impact, at least some of it. If we get negative rates, then on one hand they should boost stocks price-to-earnings ratio. (Paradoxically, the further a companys cash flow is in the future, the more it is worth in todays dollars. Yes, makes little sense to us, either). On the other hand, if we have negative rates, that means we are desperate and thus earnings are collapsing.

In an inflationary environment, most earnings growth will be eaten away by declining price-to-earnings, as it happened in the 70s.

Another issue: If you held many Nifty Fifties for 20 years, from 1972 to 1992, they would have delivered a decent (10%-plus) return. This sounds great in theory; however, most people would have run out of patience after a decade of no or negative returns and thus not have been around for the fruits of the 80s decade. In other words, shareholders who bought the stocks in 1970 were not the ones who benefitted from the returns in the late 80s.

Today the Nifty FANGAM has turned into one-rule stocks buy! (irrespective of price). If you did not own them over the last decade, your portfolio had an enormous headwind against it.

But what the Nifty Fifties showed us is that company greatness and past growth are not enough. Starting valuation what you actually pay for the business matters. The great companies will still be great when their stocks are down a bunch and they have a decade of no returns. Dividends aside, stock returns in the long run are not just driven by earnings growth but by what the price-to-earnings does as well. If price-to-earnings is high, its mean reverts declines chipping away at the return you receive from earnings growth. I (this is Vitaliy) wrote two books on this topic.

The 70s were almost fifty years ago. Fine, just look up Microsoft, Cisco Systems (CSCO), Coca Cola, and Wal-Mart (WMT) stock charts from the late 90s, and youll see that history repeats itself, again and again (see charts below).

What you pay for even a great company matters. Paraphrasing the great Freddie Mercury, there must be more to the stock market than FANGAM (though that has not been the case lately). They were the tailwind for the S&P 500, but theyll likely turn into a headwind over the next decade, and become an anchor around its neck.

Nifty Nineties (1990s)

And one more thing

I am not a journalist or reporter; I am an investor who thinks through writing. This and other investment articles are just my thinking at the point they were written. However, investment research is not static, it is fluid. New information comes our way and we continue to do research, which may lead us to tweak and modify assumptions and thus to change our minds.

We are long-term investors and often hold stocks for years, but as luck may or may not have it, by the time you read this article we may have already sold the stock. I may or may not write about this company ever again. Think of this and other articles as learning and thinking frameworks. But they are not investment recommendations. The bottom line is this. If this article piques your interest in the company Ive mentioned, great. This should be the beginning, not the end, of your research.

Vitaliy Katsenelson, CFA
Student of Life

I am the CEO at IMA, which is anything but your average investment firm. (Why? Get our company brochure in your inbox here, or simply visit our website.)

In a brief moment of senility, Forbes magazine called me the new Benjamin Graham.

Ive written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (Im working on a third - you can read a chapter from it, titled The 6 Commandments of Value Investing here.)

And if you prefer listening, audio versions of my articles are published weekly at investor.fm.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


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Rating: 5.0/5 (4 votes)

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Comments

Praveen Chawla
Praveen Chawla premium member - 1 month ago

The US stock market in general appears to be in a bubble.

A strong case can be built to invest outside the US. For example, the Canadian stock market is still 25% below 2007 when expressed in US Dollars.

http://schrts.co/DJUaPVJm

jinenmail
Jinenmail - 1 month ago    Report SPAM

A moment of uncertainty.

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