For a good while, it seemed like everyone was talking about FAANG. If you have been living under a rock (or at least, if you are pathologically disgusted by all things tech stock), “FAANG” is an acronym standing for Facebook (FB, Financial), Amazon (AMZN, Financial), Apple (AAPL, Financial), Netflix (NFLX, Financial) and Google – now Alphabet (GOOG, Financial).
These are the tech titans of the current market, driving the Nasdaq and accounting for much of the market strength in recent quarters. For that reason, they have been lumped together under the FAANG moniker, despite their often divergent business models and different levels of financial success.
Referring to FAANG as a group was a comforting and simple shorthand for analysts and commentators. But the second-quarter earnings season has proven just how dangerous lumping such different companies together can be.
In today’s research note, we discuss the growth of FAANG and its downfall.
Comparing apples and subscriptions
For a long time, it was easy to lump the FAANG stocks together. They were all trading at high multiples and growing rapidly. All enjoyed tremendously positive market sentiment and were seen as major disruptors in our digital age. Google dominates search and Facebook remains king of social media. Meanwhile, Netflix has redefined home entertainment with its streaming service, while Amazon has become the undisputed master of e-commerce.
Yet for all their go-go growth and Silicon Valley pedigrees, these were deeply different companies. Apple makes phones and computers. Netflix sells television and movie subscriptions. To folly of acting as if the two are fundamentally linked in some way should be obvious. Yet it became commonplace and, while everything was going smoothly, the differences of business model and potential real growth could be overlooked by analysts, commentators and the public.
Unfortunately for them, reality always bites in the end.
A toothless narrative
The folly of FAANG was thrown into stark relief during the second-quarter 2018 earnings season.
Thanks to an earnings beat, Apple reached a historic $1 trillion market capitalization. Amazon continues its own inexorable rise in the market. But not all FAANG companies could enjoy such good fortune.
Netflix was the first to fall when it reported weak subscriber growth. The stock fell hard on the news. Further blows have fallen hard on the upstart entertainment company with the advent of rival streaming services, from Hulu to Amazon Prime. Other players are also getting into the game, such as Disney (DIS, Financial), a company that, inexplicably, had a smaller market valuation than Netflix before its recent correction. The wheels have come off the story of perpetual growth and the idea that Netflix enjoyed unassailable network effects has been thrown into serious doubt.
Meanwhile, Facebook took a beating when it reported second-quarter earnings, posting lower-than-expected earnings and weaker guidance. The infinite growth story is now in question there as well.
Of course, the problems afflicting Facebook and Netflix, namely overexuberance and expectations of seemingly limitless growth potential, could be attributed to the other FAANG stocks to a degree. But the fundamentals of each business are so different that to compare their directions – other than in a general sense of tech stocks that have been bid up in a long-running bull market – is highly suspect.
Why we build systems
So if the individual component companies of FAANG are so different, why were they grouped together? As we mentioned earlier in this note, it was convenient since they were tech stocks all enjoying eye-watering valuations and meteoric growth. But why would intelligent analysts lump them together, thus obscuring their differences?
The answer lies in a quirk of human nature. All humans crave order. They want to understand what is happening. That is why we build systems and models of how things work, often oversimplifying in order for the models to be cleaner and tidier. But tidiness is no substitute for accuracy. The dangers of over-systematizing are well known in many fields. In economics, macroeconomic models are often so divorced from reality as to become wholly meaningless. Designed to explain the past with extreme statistical rigor, they break down when the forced pattern is broken by subsequent action.
The risk of BRIC think
Another relatively recent example of the “FAANG phenomenon” (or perhaps we should call it "BRIC think") comes to us from the world of economics. In a 2001 research paper, a Goldman Sachs (GS, Financial) analyst lumped a quartet of fast-growing developing economies, Brazil, India, Russia and China, into a single basket.
The BRICs soon became a shorthand across the worlds of finance, economics and politics. Yet the underlying realities of these economies were radically different. The state-managed capitalism of China bears little resemblance to Russia’s kleptocratic authoritarian system, let alone the relatively freewheeling democratic capitalist systems of Brazil and India.
When these economies began to diverge massively in the past decade, international economists and policymakers had difficulty unravelling the narrative created for them. That is the great risk of such forced systems: The are clean and convenient and can work for a while, but they are fundamentally brittle. When situations change, the psychological biases and shorthands created by such thinking can lead to poor decision-making at the macro and micro levels.
Investors must be wary of systems of any kind, but especially when it comes to anything as complex as capital markets. The international economy is a vast web of interconnected elements, but even national economies and capital markets are deeply complex systems.
Use shortcuts at your peril.
Disclosure: I/We own no stocks discussed in this article.
