Ideas Farm: Will the FAANGs BRIC it?

Disappointing numbers from video streaming platform Netflix led to a brief spell of introspection from markets about the future for Big Tech last week. Could the FAANG stocks  (Facebook, Apple, Amazon, Netflix and Google) see a similar loss of form to that experienced by the BRICs (Brazil, Russia, India and China) which they took up the momentum mantle from in 2016?

With our list of fund manager favourite tech stocks being published this week, it seems an opportune moment for the Ideas Farm to join in with the navel gazing. 

There appear to be three key things that tech worry-warts have to fret over at the moment. 

The first is the fear that long-term growth expectations could retreat. This seemed the most pressing cause for Netflix’s 6 per cent share price fall when it announced weak third quarter new customer numbers last week. This highlights concern that some tech companies have become so big that they now have less room to grow and may face increased competition. 

The second concern is that the value investors can justify putting on growth may be set to plateau, or even to fall. 

In theory, the value of future earnings is determined by the so-called discount rate, which is very dependent on the risk-free return from government debt. The lower the risk-free return, the higher the value of future profits, and vice versa. With bond yields having fallen for the past 40 years to rock bottom levels, some are wondering if this is as low as we go. An added dimension to this worry is that the lower the discount rate is, the more value can be applied to earnings in the distant future, encouraging more speculative investor behaviour in “growth” stocks.

The third concern is that growth itself may become less profitable. This is not just due to increased competition for companies like Netflix. There is momentum behind efforts to break the monopoly of certain tech businesses, such as Google's control of search traffic. This could mean grinding litigation and margin attrition for years to come.

There is a neat academic model that can be used to help illustrate the three issues. It is called the Gordon Growth Model. It can be used to give what is in theory the justified price/earnings (PE) ratio based on a forever growth rate, cost of capital (linked to the risk-free rate) and return on capital (a measure of profitability). The accompanying three tables illustrate that valuation gets most extreme, and becomes most sensitive to change, when all conditions are favourable (ie low cost of capital, high returns, and high growth). 

So when things are really great, relatively minor disappointments can be expected to get big market reactions. But then again, a neat model, while offering a nice illustration, is probably not necessary to tell most experienced investors this.