Isaiah Chapter 33 verse 22 states, "For the Lord is our judge, the Lord is our lawgiver, the Lord is our king; it is He who will save us."
There are many times that either I think I am really driving things in my life or that there are other circumstances impacting it. During these times, this verse is important for me to recognize as only God is above everything and responsible for what is happening. Responsible meaning that God allows what happens to me everyday, out of love for my benefit. Sometimes it's very hard to understand the whys, but knowing a God who is the creator of humanity and loves everyone the same is as reassuring as it gets.
For investing, wouldn't it be great if I were the judge over valuation and Stock Price, SP performance? Not really as my impact would be far to narrow-sighted and only self-benefitting. The reality is that the market always determines the value and SP for every publicly traded company. Trying to consider the market's longer term trends can be helpful in considering the future. Just as emotion impacts how I view my life, the same challenges are always present for stock analysis.
Peak FAANG-M is here. Not only is it here, but the pandemic has served as a catalyst towards reaching the climax, while also delaying the inevitable slowing growth trends that were clearly prevalent pre-pandemic. In some respects, the pandemic has both generated and masked peak FAANG-M.
I assume nearly everyone is familiar with who FAANG-M are, but if not here are the listed companies:
Facebook, Inc. (FB)
Amazon, Inc. (AMZN)
Apple, Inc. (AAPL)
Netflix, Inc. (NFLX)
Alphabet, Inc. (GOOG)
Microsoft Corporation (MSFT)
I write this blog from an aggressive growth stance. This is important as first, FAANG-M were once all great aggressive growth opportunities during varying stages of their business for investors. I think it's important to note that for investors with very solid positions, by no means do I think that liquidating makes sense. For some it may, for others it may not.
The key point here is that FAANG-M is at a peak, most notably from the core metrics of valuation, and that this peak level of growth performance is not sustainable moving forward. From my investment perspective I see key themes justifying why FAANG-M's best growth days are over, and for an aggressive growth oriented investor like myself, why I don't plan on holding any of these companies for the mid- and long-term future. These key themes are as follows:
Risk - equity risk in particular thinking about degrees of risk versus various sized companies, including stage of business cycle
Valuation - notably valuation of some of the largest companies in the world versus smaller growth peers
Innovation - companies that thrive over time must be risk takers, it doesn't matter how big or small a company is, what are the indicators of willingness to take risk
The key point I think is most valuable to emphasize here is that all equities bear risk. And while some believe that there are inherently safer equities to own, I contend that over longer periods of time, nearly all equities at some point will witness substantial volatility. This means that regardless of the company one owns, seeing it drop towards 30-50% is going to happen, whether recession/depression, misstep, competition (perceived/real), etc. For me, this begs the question as to why I would be willing to take similar risk, while getting a lower return for it. This is precisely the point with FAANG-M. Yesterday's leading growth companies will not be tomorrow's leaders from an investment return perspective.
FAANG-M and others like Walmart, Inc. (WMT), PepsiCo, Inc. (PEP), Visa, Inc. (V), just to name a few, are all similar in that they have achieved robust growth, and now are so-called "safer" investment options versus today's aggressive growth peers. I beg to differ, especially for investors who are younger and/or seeking aggressive growth, and especially with respect to risk.
As all of these companies mentioned above (as well as many more) have achieved significant scale, they no longer are nimble enough to substantially drive growth. As such, they become dependent upon dividend payouts, share buybacks, acquisitions, among other items to continue to appease investors for slower growth, while still attempting to drive the business forward. These tactics are a far cry from what built them, and are a direct reason why newer, younger competitors thrive on innovation and risk-taking to compete and successfully take market share.
For me, this equates to larger companies often bearing equally or in some cases, higher degrees of risk as they become more complacent with appeasing shareholder priorities such as dividends and/or share buybacks over risk taking. During higher growth stages, re-deploying all investments back into the company, whether by strategic deals or through operational support and capital investments, were core practices to fuel growth performance. I would go so far as to say that once a company begins down the road of dividend/share buyback prioritization, they have essentially sacrificed resources and priority for innovation.
This places multiple risks for "fat cats" versus their more lean and focused aggressive growth competitors that are not going to compromise on taking market share when it comes to resources. But the flip side is that the public narrative tends to focus on the "safer" perspective which is more counterproductive to fully divulging key issues. Broadly, risks whether competitive or not in my book are mostly mitigated by the degree of risk taking as a counter-measure. How does a company compete most effectively - by being strategic and aggressive when it comes to risk taking. There is no better indication of risk.
There are essentially two ways to value a company. One, Enterprise Value per Revenue, EV/Revenue, notably for companies that are not yet able to generate Cash Flow. The other, Operating/Free Cash Flow, OCF/FCF per share for those that are. Sure Wallstreet distorts this through financial metrics they can control and collude with companies on, but any sophisticated investor will recognize Cash Flow is the primary way to assess investment potential and returns.
This is an optimal way also, to be capable of comparing all public companies across industries from a relative perspective (something that has been kept behind the scenes for far too long) - while also factoring for other variables such as operating segments, scale, competition, human capital, etc. When we consider this, we clearly see a peak in EV/Revenue and OCF/FCF/share for all FAANG-M. We also see how important and valuable the pandemic has been at accelerating growth that was clearly slowing across the board.
Below is a reflection of quick high-level review of this:
I like this overview as the average numbers in the last two columns include 2016 - 2020 so it is a combination of the low-point of growth performance from 2014-2016, the reacceleration of economic growth from 2016-2019 and corresponding inflection during 2020, versus the current peak in 2021 - first two columns.
Some companies have seen a much more dramatic increase in valuation, notably Apple and Microsoft, but all are at peak levels and all will see slowing growth for the future. Regardless, I've assumed peak valuation multiples over the mid-term which leads to the following potential Return on Investment, ROI during this time below:
This table above is indicative of the financial models underpinning the companies which is based on segment-related top-line growth projections, and associated Cash Flow margins. While some may see these potential annualized returns as suitable, they are not the type of results that aggressive growth investors are looking for. More importantly per the risk discussion above, these companies do not afford investors with a literally stronger/safety position, and are going to return lower amounts versus aggressive growth peers, a precedent that historically has been proven time over.
Innovation is highly important and also misunderstood by many investors, while easily manipulated by Wallstreet. The straight forward thesis is that innovation is inseparable from the degree of risk appetite. This is completely aligned with competitive risks and valuation, which is a direct perception and expectation of financial growth potential.
Innovation can be interpreted a few ways, but human capital is the key. From top to bottom, any company is only as good as its leadership and employees driving it. This is where companies like FAANG-M are at a crossroads. On the one hand, they have scaled significantly from their younger growth days, on the other, they are no longer leading the newer innovative markets, but always are looking at competitive angles on how to enter them. Today, this is predicated on monopolies and/or oligopolies being the standard for continued competitive pressure.
If there's one consistent theme for FAANG-M, it's that R&D spend is substantial. Per the above table, clearly R&D spend is huge with laggards being Apple and Netflix from a proportional standpoint. But equally large for R&D spend are the massive operating segments that these major companies are obligated to sustaining and growing. Facebook doesn't want to loose its advertising edge, nor does Alphabet, while Amazon, Microsoft, etc. all have specific existing operations that command the bulk of R&D budgets.
I see R&D spend as a major weakness for many investors who simply look at these numbers and assume that FAANG-M can replicate and enter into any industry that they so choose. I believe that a more true form of risk taking is directly related to investing back into the business after R&D spend, or as an alternative, the pace of R&D spend growth relative to Revenue. For aggressive growth competitors, this is mostly evidenced by a stronger growing R&D spend and/or selective strategic investments, whether through partnerships or direct acquisitions.
This is where falling victim to share holder buybacks can altogether thwart risk taking. For me, it is a red flag in that a company no longer sees any benefit to increase R&D spend relative to Revenue, directly grow assets for the business operations, or look to strategic investments. I see it more as a defensive strategy, and highly conservative. Today's world with FAANG-M is more so dependent on being an extension of government to keep the status quo.
My favorite example to tie things together out of FAANG-M is Apple. Apple only spends 6% of their operations on R&D, while the company has spent nearly $400 billion the past eight years on share buybacks alone. Apple is one of the most talked about companies with respect to Total Cash which currently stands at $194 billion. But based on share buyback trends, in three years or so Apple will actually have Net Debt.
So the laggard when it comes to R&D spend proportionally has wasted hundreds of billions of dollars on inflating EPS, while OCF/share has grown annualized by 10% or so the past four years, but only 5% nominally. And through the most current fiscal year 2020 Apple has also concurrently witnessed 6% Revenue growth, but the Stock Price, SP has surged an annualized 48% with the pandemic being the catalyst. Apple's fiscal year ends September 30th, so much of last year's pandemic is in the numbers for financial performance for 2020. Whether looking at OCF/share including share buybacks or not, there is no justification for the current multiple expansion of nearly 45%.
The risk from today's SP for Apple is very real and in many cases higher than aggressive growth peers simply based on the fundamentals. And yet today's mantra from Wallstreet is focused on the debate on whether aggressive growth peers can sustain current valuation, especially with inflationary concerns, etc. This is beyond irrational as some aggressive growth peers have displayed further inflection of both Revenue and Cash Flow performance through the mid-point of 2021, and will not fall as hard once the benefits of the pandemic are no longer prevalent, with respect to their operations.
The primary difference between FAANG-M and leading aggressive growth plays is that FAANG-M got a one-time injection (pun intended) of winner-determined economic performance. This is based upon the current Big Tech - Big Government connection. The reality is that this is not part of the leading innovators forming the paradigm shift afoot for changes to expanding economic efficiency, that will benefit a much wider group of people, both within the U.S. and globally. For those continuing to expect that FAANG-M will see further significant upside potential from here, I would exercise some serious caution, and at a minimum, strong scrutiny of what really drives investment performance.