The five big technology stocks comprising the FAANG group turned in a stellar 2017, delivering an average return of 49%, versus 22% for the S&P 500 Index (SPX) as a whole, according to Barron's. Also, the S&P 500 Information Technology Index rose 37% in 2017, per S&P Dow Jones Indices. As a result, one obvious route to beating the S&P 500 last year was to be overweight in tech, especially the FAANGs. Barron's warns, however, that continuing to bet heavily on tech is a risky course for investors. Meanwhile, according to Fortune, "the tech explosion" may have negative long-term consequences for investors. (For related reading, see: Expect Less From FAANGs in 2018: Morgan Stanley.)
FAANG vs. FAAMG
The FAANG stocks include Facebook Inc. (FB), Apple Inc. (AAPL), Amazon.com Inc. (AMZN), Netflix Inc. (NFLX) and Alphabet Inc. (GOOGL), the parent of Google. An alternative set of five big tech stocks, the FAAMG group, includes Microsoft Corp. (MSFT) rather than Netflix.
Barron's notes that the FAANG stocks constitute 13% of the capitalization-weighted S&P 500. Fortune, meanwhile, finds that the FAAMGs contributed 5.2 percentage points of the 23.7% total return that they computed for the S&P 500 in 2017. Microsoft has a much larger market cap than Netflix.
'Slim Earnings, Rosy Promises'
"Big-cap tech, with slim current earnings and rosy promises of future growth, are some of the longest-dated stocks around," Barron's observes. Moreover, much of the 2017 gains were propelled by higher valuations: the P/E ratio for the tech sector rose from 21.6 to 24.5 last year, per calculations by Bespoke Investment Group cited by Barron's, making it the second-priciest slice of the S&P 500 after energy.
For the FAAMG stocks, Fortune computes that this group saw its collective P/E shoot up from 22 to 27 in 2017, while the S&P 500 ended the year at a P/E of 23. Meanwhile, the biggest FAAMG component, Apple, "is showing no pattern of growing earnings," Fortune adds.
At such lofty valuations, earnings disappointments are bound to have major negative impacts on the prices of tech stocks. If the economy falters, and consumer spending falters, Amazon, Apple and Netflix could be hurt. If advertising budgets are slashed, Facebook and Google may see their revenue growth stall. Additionally, as interest rates rise, the present value of those expected earnings from far off in the future will plummet. (For more, see also: How the Fed May Kill the 2018 Stock Rally.)
Another looming risk is the specter of government regulation targeting big tech firms. Google is facing antitrust action by European regulators, Facebook has come under attack as a conduit for "fake news" and an enabler of foreign meddling in U.S. politics, while Amazon is rapidly becoming a quasi-monopoly in retailing. All the big tech firms are raising concerns over their massive collection of personal data.
'Heavy Drag on Future Returns'
Meanwhile, for the growing number of investors who have made index funds a significant part of their portfolios "a heavy drag on their future returns" may result from "the tech explosion," Fortune warns. Index funds, as they explain, are cap-weighted. As tech stocks have soared in price, outpacing the broader market, they have become a larger percentage of both the major market indices and of the index funds that track these indices.
The result is that these index funds become "heavily weighted in the priciest companies," per Fortune. That's counterproductive, they add. "Decades of research shows that a methodology that lowers exposure to the most expensive stocks, and favors cheaper shares, produces the best returns," as Vitali Kalesnik, head of equity research at Research Affiliates LLC, told Fortune.
Kevin McDevitt, a senior research analyst at Morningstar Inc., expressed similar concerns. "Seriously consider rebalancing into other funds with less tech exposure if you have a fund with a large tech overweight," he told Barron's.
Based on analysis by Morningstar, Barron's found five big actively-managed mutual funds (i.e., excluding index funds) with at least $400 billion of assets whose weightings in the FAANG stocks are at least twice the 13.0% FAANG weight in the S&P 500. Darren Bagwell, who manages the Thrivent Large Cap Growth Fund (THLCX), has a "great deal of conviction" in the FAANGs, which are 31.6% of his portfolio, topping Barron's list. His team looks for companies that are dominant in their markets, with revenues growing two or three time faster than GDP, strong cash flow and low leverage.
The Prudential Jennison Focused Growth Fund (SPFAX) has a 26.0% FAANG weight per Morningstar and Barron's. Managers Sig Segalas and Kathleen McCarragher look for companies that generate economic value over many years, have strong balance, invest heavily in R&D, have defensible franchises, and which demonstrate strong secular growth. FAANG members Facebook and Netflix are among the companies that meet these criteria for them, Barron's indicates.