Tag Archives: FAANGs

Are Tech Stocks Cheap?

Are technology stocks cheap? It seems like a strange question to ask as the market drops on news that Apple has indicated weaker future sales. I also doubted whether Facebook’s price reflected its business value in the middle of this past summer. I thought fair value for the business was around $140 per share assuming it could grow its free cash flow by a robust 6% annually over the next decade. The stock is now in the $130 range after pushing higher than $200 in the early summer.

But technology isn’t just the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). And at least two important firms – DoubleLine and GMO – think the sector is at least relatively cheap. Here’s why.

First, technology is trading cheaply on a Shiller PE basis, shown by the fact that the DoubleLine Shiller Enhanced CAPE Fund (DSEEX) holds the sector. By using a bond portfolio as collateral, this fund gains exposure to an equity derivative that delivers exposure to four of the five cheapest S&P sectors (tossing the one with the worst one-year price momentum) on the basis of their Shiller PE ratios — and technology is one of those sectors currently. The Shiller PE, as a reminder, is the current price of a stock, sector, or index relative to its past decade’s worth of real, average earnings. Right now (and for more than a year) technology has come up as one of the four sectors the fund owns, meaning its Shiller PE is lower relative to its own historical average than other sectors’ Shiller PEs are to theirs. The other sectors the fund owns currently are Healthcare, Consumer Staples, and Communication Services.

This mechanical application of the Shiller PE may not satisfy investors looking for more a more absolute definition of value, but, relative to other sectors, technology is cheap on a serious valuation metric. If you’re going to be allocated to U.S. stocks in some way, shape, or form, this is a reasonable way to achieve that allocation.

Second, GMO, which is also a fan of the Shiller PE metric, and uses it in its asset class valuation work, also likes technology stocks. The Boston-based firm just published a white paper, written by Tom Hancock, the head of the firm’s Focused Equity Team, arguing that technology stocks were attractive. The firm’s “Quality” strategy has 45% of its assets in technology stocks, “including positions in three of the five FAANG stocks.” Alphabet (Google) and Apple are the two largest holdings of the firm’s Quality mutual fund (GQETX), managed by Hancock.

Rather than relying on traditional valuation metrics when picking individual stocks, the firm looks at how Alphabet, for example, invests in R&D, and how that investment can translate into higher future revenues. In other words, R&D isn’t properly counted as an expense that will never yield future revenue and earnings growth. On the basis of accounting adjustments like this, GMO views Alphabet as a cheap stock.

Hancock notes that GMO’s Quality portfolio doesn’t trade at traditional valuation multiples that are different from the broader market. But, “in an expensive market, quality companies typically trade at higher P/E’s than most ‘value’ investors would like.” Higher multiples are justified for companies with resilient margins and strong business models, and Hancock thinks the strategy can produce returns of 5% in excess of inflation.

Quality companies in the U.S. are also cheaper than those outside of the U.S., and Hancock surmises that’s because of a kind of scarcity value. Companies with consistently high margins and returns on invested capital are less prevalent outside of the U.S., so they trade at dearer prices.

Moreover, the U.S. technology sector consists of a diverse group of stocks. Only one of the FAANGs – Apple – is in the top-10 of the S&P 500 Information Technology Sector. Some of the largest constituents of that sector are the darlings from the technology bubble of nearly 20 years ago – Microsoft, Intel, Cisco, and Oracle. They turned out to be good businesses that were just overpriced then. Hancock lists Microsoft’s virtues as being in the cloud growth business and having a lock on the consumer. Qualcomm, by contrast, has a unique position in the smartphone supply chain, while Oracle provides legacy software and benefits from high switching costs. Finally, Visa and Mastercard are “borderline tech” companies, but, nevertheless, find themselves near the top of the S&P 500 Information Technology sector.

So, despite being known for top-down asset class valuation calls, the GMO Quality strategy is bottom-up and fundamentally oriented. And, just like the more mechanical, single-factor approach of the DoubleLine fund, it also finds technology stocks cheap – or cheaper than their brethren in other sectors.

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Both the DoubleLine Shiller Enhanced CAPE fund and the GMO Quality III fund are worthy of investors’ consideration. Beware that the latter is for institutional investors, given its $10 million minimum. Get in touch with us if you have questions about portfolio construction, asset management, or financial planning.

Own The Company That Dropped Its “Don’t Be Evil” Motto

Most investors know what the “FAANG” stocks are – Facebook, Apple, Amazon, Netflix, and Alphabet (parent of Google). These stocks have had big runs over the last few years, and they’ve struggled more than the market over the past few months. That’s typical behavior for growth or glamor stocks – higher than the market when it goes up, and lower when it goes down.

Of these stocks, which one has the best long-term prospects? If you had to own one for the next 10 or 15 years, which one would it be? I think all of them, except for possibly Netflix, have strong business models, but I would pick Alphabet (Google). Here’s why.

Although I’m not sure he means to, Jonathan Tepper lays out the case for owning Google in his recent book, The Myth of Capitalism: Monopolies and the Death of Competition. When I was reading this book, I found myself enraged at how the tech giants have managed to become monopolies, but also wondering how much of my money I could stuff into their stocks. Google stood out to me as being a particularly bad actor, but also one whose future profits the selfish part of me wanted to own.

Tepper begins his story about Google by reciting what the search juggernaut did to a firm called “Foundem.” Foundem gave users the ability to search for the best price on a desired product. Somehow, although Foundem enjoyed an initial wave of success with shoppers rushing to use the site, “suddenly, after the second day, users never came back,” as Tepper tells it. It turned out that by the second day Foundem had dropped 170 pages down when shoppers searched for it after being at the top of the search list initially. Google removed Foundem from its organic search results and also prevented Foundem from purchasing ad placements via Google AdWords. Google “disappeared” Foundem, the way people get disappeared in totalitarian regimes. Google had its own product search service that it wanted to promote, and Foundem presented unwanted competition.

Google has done similar things to other companies in its ambition to grow its basic search business through ancillary “verticals” or searches in specialized areas – real estate listings, local business directories, legal filings, price comparisons, images, etc…., according to Tepper. For example, Google noticed that searches like “where’s the best nearby steakhouse” were becoming popular, so it decided to appropriate Yelp’s reviews. That meant Google users could see the Yelp reviews on Google, and bypass Yelp entirely. Yelp complained, eventually to the F.T.C., but Google’s response was that Yelp’s only alternative was to remove its content from Google altogether, according to this NYTimes article.

Google did similar things to other review sites such as TripAdvisor, and Cityserach, and it also allegedly provided pressure on cellphone manufacturers Samsung and Motorola to prevent them from using a navigation system in their phones called Skyhook. Google also adjusted how it displayed images so that its users could see and download Getty Image’s photographs without going to Getty’s website. The Times article quoted Getty’s attorney, Yoko Miyashita, saying he received a response from Google to Getty’s complaint that basically argued, “’Well, if you don’t agree to these terms, we’ll just exclude you.’” Miyashita said that wasn’t really a choice because if you’re not on Google, you basically don’t exist.

Over the past decade, Tepper calculates that Google, Amazon, Apple, Facebook, and Microsoft have collectively purchased 436 companies, mostly without antitrust interference.  It’s possible that the tide is turning against Google, and that it won’t be able to do to rivals in the future what it has done to them in the past – buy them, appropriate their content, or prevent them from appearing in searches. But, according to Tepper, Google already controls nearly 90% of search advertising. Advertisers want to be there because that’s where search is happening. Searchers want to be there because that’s where they’ll find what their searching for.

So far, Google has managed the neat trick of censoring or manipulating what people search for without offending them or incurring the wrath of the Justice Department. At some point the firm gave up its “Don’t be Evil” motto, perhaps realizing it couldn’t live up to that. But that means if you want to bet on one FAANG stock for the next decade, and you can swallow your moralism, Google probably has the best shot at continuing to deliver high returns.

Facebook Follow-up: Looking At Two Other Tech Darlings

Well, that was fast.

I published an article on Monday wondering about Facebook’s valuation, and on Thursday Facebook dropped around 20% in the wake of its Q2 earnings report, putting in the worst day for a stock in market history on value lost (nearly $120 billion) basis. The report showed robust 42% revenue growth, but that number was below expectations, and, more importantly, the online social media firm warned about future revenue weakness. Facebook will have to hire more personnel to police the “bots” posting on its site, and that will cut into the firm’s prodigious margins.

In my article, I “reverse engineered” a discounted cash flow model to show that the market was assuming 6% free cash flow growth and more than 12% revenue growth for the next decade. Today’s market price for Facebook assumes a 4% FCF growth rate – a 33% reduction from yesterday’s price.

So how do other tech giants look these days? Are they all poised to tumble like Facebook? Some are and some aren’t.

Alphabet

Alphabet is often compared to Facebook. Both companies are in the online advertising business along with the ancillary business of finding out as much information about, and invading the private lives of, consumers as much as possible.

It turns out, the market is making almost the same set of assumptions it was about Facebook before its drop. The free cash flow growth rate that allows a model to arrive at today’s current stock price as the fair value for the business is 6.5% — just a bit over the 6% rate that Facebook’s stock price assumed before it’s crash.

As I said in my previous article, I haven’t studied the online advertising market, so I don’t have an opinion on whether Alphabet can grow this much. Alphabet turns a little more than 20% of its revenue into free cash flow. That makes it around half as efficient in this regard as Facebook, though Facebook’s ratio may well shrink in the future based on its need to pay more people to police its platform.

Alphabet is involved in more diverse array of business than Facebook is. Its Android operating system is in many of the world’s mobile phones. Its Internet browser, Chrome, is popular, and its subsidiary Waymo, is involved in the development of self-driving cars, though Facebook has also made efforts at driverless cars.

Growth isn’t easy to predict for companies like Facebook and Google, and the similarities implied by doing these reverse discounted cash flow models may indicate that analysts and investors, up until Thursday, had picked nearly the same growth number for both companies out of convenience.

None of this means Google is the next technology stock to tumble though. Future quarters may disappoint investors the way Facebook’s recent quarter did, but they may just as well impress the market. Everyone now will have to persuade themselves whether the optimism baked into Alphabet’s price is justified. For at least the two days of trading this week after Facebook’s stumble, it seems they have.

Tesla

Speaking of driverless cars, Steve Eisman, a manager profiled in Michael Lewis’s The Big Short, thinks another popular technology company, Tesla, isn’t doing enough to make inroads in that area. Indeed, the electric car maker has burned through more than $8 billion in cash over the last four years, $4 billion last year alone. It shows no signs of being able to generate positive cash flow.

Its current market capitalization of around $50 billion assumes one scenario (shown below) whereby it somehow produces $1.7 billion in free cash flow next year and grows that number by 5% annually for the next decade. This would be nothing short of miraculous for a company that has lost so much cash already. Perhaps it’s unwise to count Elon Musk out, but investors should think hard before sinking money into an enterprise that hasn’t been able to generate free cash flow for so long. Second thoughts are especially in order for those contemplating buying shares given Tesla’s nearly $10 billion debt load and the nearly $0.50 billion interest payments it made last year.

Conclusion

It’s hard to know if Facebook’s (and now Twitter’s) problems represent the technology sector’s comeuppance. Facebook produced more than $17 billion of free cash flow last year, and it’s still a healthy company even if investors are re-thinking past assumptions about its growth and profitability. Not all of today’s technology firms have as unlikely a road to success and to posting the profits that justify their stock prices as Tesla.