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John Kinsellagh
John Kinsellagh
Articles (155) 

FANG Grouping Distorts Value vs. Growth Distinction

From a valuation standpoint, there is no reason for lumping Netflix with Microsoft

The past few weeks have tellingly demonstrated the hold the FANG stocks have had on tech stocks in particular and the entire market in general. It has become manifestly apparent that the cause-and-effect relationship between individual members of the group has an appreciable impact on the direction of the entire market — regardless of the underlying differences between the individual companies.

The fact these stocks have tended to move in tandem has had the effect, at times, of badly skewing pricing of the market as a whole and for each of the FANG’s constituent members.

The valuation of the FANG stocks tends to obscure the difference between members of the group, which are now becoming more pronounced.

The grouping now makes little sense. The differences between the members now far outweigh any similarities to the extent that the rising fortunes of one member of the group should elevate the stock price of its remaining members. Some members are now competing directly against each other. Apple’s (NASDAQ:AAPL) next operating system is going to allow users to block Facebook’s (NASDAQ:FB) tracking mechanisms. Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) are locked in an increasingly high-stakes cloud services duel.

Since the FANG constituents in many investors’ minds are fungible, some have become used to substituting one member of the group for another. Since the group tends to move in tandem, an increase in one stock tends to lift the entire group. That is exactly what happened when Apple reported its latest earnings and then subsequently won the trillion-dollar sweepstakes.

The pricing for each of the FANG stocks now rests on a Three Musketeers valuation model: all for one and one for all.

Consider how the FANG index acts in a disproportionate manner and can obscure the criterion for distinguishing between growth and value stocks. When the FANG group fell at the end of July, it dragged the entire market down and heightened the cause-and-effect relationship between the growth and value sectors. According to data from S&P Dow Jones Indices, approximately 60% of the companies in the S&P 500 that are characterized as growth were down on the last day of July, while members of the value index were up by the same approximate percentage.

An examination of the discrepancy between the two sectors for the past three years is telling: since 2015, including dividends, the Russell 1000 growth index has increased by 65%, while the value index returned only 30%. The Russell 1000 growth index trades at 21.4 times estimated forward earnings.

One can argue that value stocks are “expensive” today because they were previously much cheaper, but the comparison is relative: with a 14.3 times multiple, these stocks are bargains when viewed against the exorbitant prices of the growth companies. For those enterprising investors, it should be noted that Amazon is currently trading at a price-earnings ratio of 150. In short, growth stocks today, in terms of multiples, are getting prohibitively expensive.

Indeed, for some investors, the disparity in pricing is so great that even though it has lagged the market as a whole, the consumer staples sector looks undervalued.

Each member of the FANG group is at a different stage in the growth cycle. Additionally, as advertising becomes a substantial source of revenue for relevant members of the group, e.g., Facebook, Alphabet's (NASDAQ:GOOG)(NASDAQ:GOOGL) Google and Amazon, and as members compete against each other, operating margins are bound to fall. This scenario is starting to play out as Apple and Amazon each have entered the original content digital streaming market and will be competing with the Netflix (NASDAQ:NFLX) Goliath.

There also seems to be a disparity in terms of rational valuation in terms of the effect of government intervention or the prospect of regulatory action will have on the fortune or earnings growth potential of each member in the “growth” or FANG grouping. The recent distinction the market has made, it could be argued, is not entirely rational. It shrugged off the $4.3 billion fine assessed against Google by the European Union, but drove Facebook shares down more than 20% on news of impending regulations.

Although Facebook has rebounded, its swift decline on what was perceived as bad news is foreboding for the growth potential of this stock. Perhaps it’s time for enterprising investors to consider Facebook a more mature, advertising-dependent company, instead of a traditional “growth” stock.

The fact the rising tide of Apple recently lifted the other boats in the FANG tech group is a testament that the linking is not yet over. But as the companies continue to diverge, pricing models will need to adjust accordingly.

Disclosure: I have no positions in any of the securities referenced in this article.

About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

He is the author of "The Mainstream Media Democratic Party Complex" and "Election 2016," both available on Amazon. Follow him on Twitter @jkinsellagh.

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