The recent market volatility and corresponding drop in the tech sector has spooked many investors as it heralds a radically different investment environment than that which has prevailed for the past decade. Yesterday’s 600-point drop in the Dow was followed by a drop in the tech-heavy Nasdaq Composite, sending it to its lowest level since 2011.
Once a pillar that helped propel the decade-long bull market as well as the market’s 2018 gains, the turbulence in the tech sector demonstrates these stocks have not been immune from the effects of the prolonged volatility. In today’s uncertain investment environment, for those long-enamored with the FANG group, a question arises: what lies ahead for the tech stocks in general and the FANG group in particular?
Two factors are now going to attain increasing prominence for determining the health of the tech sector, especially for some members of the FANG group. The most ominous long-term investment risks for these particular tech stocks are twofold. First, the inexorability of increasingly substantive and burdensome regulations for the entire tech sector. Second, a potential collapse of questionable valuation methodologies or techniques, leading to a reassessment of current generous multiples. These are all fundamental and qualitative factors, most of which are difficult to quantify but are nonetheless serious for the long-term viability of tech stocks.
The prospect of regulatory oversight is a factor that some analysts have consistently downplayed, arguing these risks have already been discounted by the market and factored into the current stock price(s). This, however, is a rather dubious assertion that will come back to haunt those who believe the risk posed is de minimis. The unpleasant reality is that regulatory risks have not been adequately factored into current valuations.
The very core business models of Alphabet's Google (GOOGL, Financial) and Facebook (FB, Financial) have generated adverse publicity, enhanced public awareness and raised the eyebrows of lawmakers.
Apple (AAPL, Financial) CEO Tim Cook recently blasted the entire data harvesting business. This comes on the heels of Cook’s thinly veiled rebuke of Facebook CEO Mark Zuckerberg shortly after the Cambridge Analytica scandal. Data manipulation has increasingly been the subject of scrutiny and intense criticism. The deleterious effects on society and on individual’s privacy rights is going to spawn more significant legal and regulatory responses to the abuses and inordinate power wielded by some of the FANG members.
Ever since the Cambridge Analytica scandal, both Google and Facebook have continued to mislead regulators as well as the public concerning how they profit by manipulating and selling private data to third parties without customers' knowledge or consent. For companies whose entire business model depends on such data warehousing, these continuing infractions should come as no surprise.
These incidents reveal a lack of good faith on the part of Facebook and other social media titans who have operated with impunity in a regulatory-free environment for over a decade. Since social media companies have shown little interest in implementing meaningful privacy safeguards that are easy for consumers to comprehend, regulators will keep filling in the gaps necessary for users to make informed decisions.
This is going to further erode Facebook and Google’s ability to maximize revenue from their original and extremely profitable business models. Those analysts who believe Facebook will continue to generate operating margins of more than 30% under this coming scenario are deluding themselves.
Europe's General Data Protection Regulations will increasingly be more stringent and exacting on the giant social media companies' core business processes and, over time, will have a substantial effect on earnings. U.S. regulators are poised to follow suit.
An additional future risk for investors relates to the breath of ownership and the all for one, one for all price movement behavior of the FANG group. Given the crowded FANG trade, a panic selloff in any one member of this tech grouping would spare none and, if past experience is any guide, could lead to a precipitous drop in the price of all of the tech stocks.
After providing much of the momentum for the market’s meteoric and unbroken rise during a bull market of unprecedented duration, some analysts have viewed the recent drop in the tech sector as a buying opportunity for these companies whose current growth rates they believe will carry on indefinitely. This strategy has been seductive and alluring, as the FANG group has returned 38% annually since 2014.
Many of these same security analysts contend that despite their exorbitant valuations, the tech stocks are still priced “reasonably” relative to the “market as a whole.” This analysis is becoming increasingly specious. Given the pronounced volatility in the market recently, perhaps it’s time to examine the converse of this valuation proposition.
If tech stocks have been the prime or substantial mover of the market for the past year (on top of helping to drive the long 10-year bull market), what happens if any one member of the FANG group falters? Since the FANG group exerts and has exerted a disproportionate effect on some of the major indexes, a drop in one or many of the tech stocks will drag the overall market down in tandem. How does one then assess the sky-high valuations of the tech stocks relative to the “market as a whole” in such a downturn scenario?
Additionally, this valuation justification for the high-multiple FANG stocks is dangerously predicated on the bull market never running out of steam and is made by some who have never seen or experienced a down market. Analysts who seem to have an unduly optimistic and backward-looking belief that the trajectory of the FANG group will always remain skyward should know that history can be an unforgiving teacher.
The justification for the exorbitant price of the tech stocks is beginning to sound like the dot-com era necessity for new valuation models to support initial public offering market capitalizations for many startup enterprises with no earnings.
A dramatically changing investment climate as well as inevitable, costly and oppressive regulations will continue to erode the viability of the current valuation models for many members of the FANG group. Those who fail to heed the early warning signs do so at their own peril.
Disclosure: I have no positions in any of the securities referenced in this article.
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