The market value of big technology companies such as Facebook, Apple, Amazon, Microsoft and Alphabet (Google) have risen much faster than the market average over the past decade. Christophe Braun, Investment Specialist at Capital Group, believes these mega-caps can grow even bigger, as they are well-positioned to ride out a weaker global economy over the short to medium term, and have the opportunity to monetise new or existing services that could support their share prices.
The concentration of stocks at the top end of the index is at its highest level in 30 years. The driver of this rise in concentration can be attributed to the dominance of internet and technology leaders. These companies have leveraged new technologies and the internet on a global scale, fuelling their growth and disrupting the status quo. They have also come to dominate the US investment landscape. Social media giant Facebook went public as recently as May 2012 in what was then the largest technology listing in US history; the company has grown rapidly to become one of the largest companies in the world. The five members of the FAAMG family ended May 2020 as the top five largest companies within the S&P 500 in terms of market capitalisation.
This dominance is reflected in investment returns. If investors were to put the same amount of money in a hypothetical FAAMG index and an S&P 500 ex-FAAMG index a decade ago, the value of investment in the FAAMG would have increased close to nine times the original amount. By contrast, investments in the S&P 500 ex-FAAMG index would have only doubled over the same timeframe. This highlights how robust big tech stock returns have been.
The strong investment returns of big tech stocks over the years have led to some concerns as to whether this could prompt a repeat of the tech bubble during the late 1990s to early 2000s. Back then, the share prices of much hyped dot.com companies outran their earnings potential, stretching valuations to unsustainable levels. This eventually culminated in the bursting of the infamous dot.com bubble: a classic example of what happens when company fundamentals are overlooked in favour of speculative bets.
Unlike the dot.com bubble, however, the rapid rise of the FAAMGs has been driven largely by strong growth fundamentals: revenue growth, high margins, robust free cash flows and rising profits. In aggregate, the overall profit growth of all five companies has largely been in sync with their share prices.
Valuations
Still, valuations are a fundamental component of return. Each of these five companies is a distinct set of businesses that requires thorough consideration. In terms of 12-month forward price-to-earnings ratio (PE) valuations, the S&P 500 index is trading at 22x while the FAAMGs are trading at 27x (Facebook), 105x (Amazon), 26x (Apple), 33x (Microsoft) and 31x (Alphabet), respectively. This represents a significant premium to the wider US equity market.
While the headline PE multiples might appear expensive, this overlooks the growth potential of future cash flows, opportunities to reinvest at attractive rates of return and the potential for monetising new as well as existing products and services. All these factors could benefit future earnings. Furthermore, valuations are inflated by the effects of having huge cash piles on their balance sheets. Concerning big tech, high PE multiples should not be considered a deterrent given that they have the growth potential to back those numbers up. The valuation premium is less significant when taking a forward-looking view.
Amazon, for example, has historically traded on a high PE multiple without much bearing on shareholder returns. The free cash flow generating strength of the business is masked by substantial reinvestments the company makes into new opportunities to fuel future growth. This illustrates how investors can consider more meaningful and specific ways to value these companies based on their distinct characteristics and on an individual basis, rather than focus on simplistic PE multiples.
Regulatory risk
The fact that, with the exception of Microsoft, the FAAMGs are due to appear before the US House Judiciary Committee as part of a broader antitrust investigation, signals rising regulatory pressure. However, for the likes of Facebook and Alphabet, which have faced similar probes in the past, it could be argued that this risk is already reflected in valuations. Changes in taxation are another potential source of risk. For example, many countries in Europe have or are in the process of implementing a digital services tax. These risks are important when considering FAAMG stocks.
Looking more broadly, the economic environment can be considered another source of potential risk. The past decade has been an era of low growth, low interest rates, chronic debt levels and disinflationary pressures across many developed markets globally. In this environment, companies with the ability to generate sustainable growth are attractive. The FAAMG have been rewarded for their growth by the market through strong returns.
Covid-19
With work-from-home policies being implemented across the globe, individuals, businesses and communities are more reliant on digital services and solutions than ever before. Given the nature of the virus and government responses, it has reinforced big tech’s dominance in key digital services. In addition, the outbreak has brought into acute focus issues that could influence companies and share prices.
Scale matters, more than ever. Liquidity and access to capital could potentially become an issue, particularly for smaller companies that lack the financial strength to weather acute short-term impacts on revenues. Disruptions caused by COVID-19 have also highlighted the importance of digitalisation, reaching customers without a physical presence. Further, companies with scale and financial strength are better placed to invest for growth, even in challenging times.
Despite lower interest rates across many developed economies, debt levels have come into sharp focus, especially as defaults and bankruptcies continue to rise. Companies that have used debt to finance share buybacks, or serial acquirers that have taken on too much debt, are losing credibility. Investors are increasingly focused on balance sheets, liquidity and risk management.
The above factors are largely positive for big tech. The acceleration of digitalisation, and the benefits of scale and asset-light business models for internet platforms have been clear. The FAAMG also possess strong balance sheets with surplus cash reserves that are being consistently reinvested to build up business moats. They are therefore well-positioned to ride out a weaker global economy over the short to medium term. Furthermore, they operate in areas with high barriers to entry, have long-term growth runways and opportunities to monetise new or existing services that could support their share prices.