Originally published June 1 at 8:00 a.m. EST
And for that reason Jim Cramer has nicknamed them FANG stocks.
--Jim Cramer, "Does Your Portfolio Have FANGS?," February 2013
Back in February 2013 my pal Jim "El Capitan" Cramer brilliantly (and well-ahead of anyone else) coined the term "FANG" stocks --Facebook (FB) , Amazon (AMZN) , Netflix (NFLX) and Google, now Alphabet (GOOGL) .
Thursday morning, I present some serious questions about the "A" and "N" in Jim's "FANG."
With Amazon and Netflix both hitting all-time highs and Amazon having finally traded at more than $1,000 a share, the media is awash in stories about how these four "super stocks" and others that have captured most of the market's gains in this bull cycle. Indeed, it has been a subject I repeatedly have addressed in my Diary.
As a survivor of the "Nifty 50" with growth stock investor Putnam Management in the 1972-1974 period and as a short seller during the dot.com boom in the late 1990s, I have seen the movie before.
In 1972-1974, being young and impressionable, I actually bought into it. As the Internet bubble developed in 1999-2000, not so much as I became skeptical, delivering lectures and articles for various analyst societies and penning an editorial in Barron's "Other Voices" which highlighted the fantasy of technology valuation in "Kids Today." In that editorial, I warned that bear markets were borne out of conditions like the heady tech stock party that was being experienced in the late 1990s. The market, I surmised, was beginning to lose its moorings. I used the sage advice of "Adam Smith" (a.k.a., George Goodman) and "Scarsdale Fats" (a.k.a., Bob Brimberg) to illustrate my points. Three years later, the Nasdaq began a 75% decline in prices.
In the current bull market cycle and four years after Jim's creation, FANG & Co. (who knows what history eventually will call them) continues in its prominence and many again are analyzing these leaders and their rising role in a narrowing market.
Over the last week this has occasioned a lot of thinking about this, for reasons discussed below.
Here are my conclusions.
The analysis used for it is hardly being done at all except possibly by older fools who have lived through speculative bubbles and can talk about it.
Though I would not be a buyer at current levels, I can find little fault with Facebook and Alphabet shares as attractive investments (subject to more reasonable pricing) over time. Based on what I believe to be solid forward growth, neither is expensive.
For what it is worth, I estimate Facebook will grow Ebitd at 30% annually over the next few years. For Google, that growth in cash flow is about 15% per year. Moreover, both generate significant free cash flow and both currently show revenue growth in excess of my estimates for Ebitd growth. Given the low cost of goods sold for both firms, they have great control over cost and can manage reported Ebitd.
Facebook is terrific about over estimating expense growth on its conference calls. A reasonably intelligent case can be made that Google is a value stock.
For Amazon and Netflix, the valuations are another story. I would avoid both.
Amazon is a truly great consumer service. However, it makes little economic profit. Home Depot (HD) and Walmart (WMT) would be great as well, but they both generate handsome returns on investment capital, pay significant and growing dividends and generate meaningful free cash flow. Amazon currently makes $13 billion on trailing 12-month Ebitd. This is pretax operating cash flow and, in certain cases, may equate to economic profit. However, the components of that $13 billion are rarely parsed by analysts. They are interesting:
* $8.7 billion of the $13 billion in Ebitd is comprised by depreciation. This happens when a firm invests in assets. All you have to do to get depreciation is to build "stuff."
* $0.4 billion of the $13 billion in Ebitd is interest. This is not currently growing (a good thing), but it is also not shrinking (not a good thing). Share count is up slightly over the last year. Amazon is, more or less, cash-neutral. For it, interest is the cost to finance assets.
* Only $3.8 billion of the $13 billion in Ebitd is pretax income. This is growing at a 50% annual rate over the last few quarters. However, the market currently capitalizes this at 128x! (Amazon probably will not pay income taxes in anyone's investment horizon.) This is an extraordinarily high multiple. A good rule is one unit of multiple for each unit of growth. Amazon sells at over 2.5x. That was as good as it got in 1972-1974. In addition, there are subtle warning signposts. (Please continue to read and learn about this!)
* Amazon seems to be suffering from a declining marginal productivity of capital. In plain language, it may be running out of investment opportunities. In the last four years, revenues doubled while depreciation more than tripled. Amazon's latest "growth" opportunity is furniture. Last time I looked, furniture retailing was a low-multiple, high capital-intensity business.
Watch More: Take a Look At Amazon's Amazing Journey
Netflix is a different situation. The market wants it to grow subscribers and could care less about the cost of doing so. Netflix does NOT invest in fixed assets. Depreciation has been more or less flat at $15 million for each of the last nine quarters. Like Amazon, Netflix is a great service for the consumer. With Season 5 of "House of Cards" just releasing, Netflix, like Amazon, recently hit an all-time high in share price.
* However, NFLX is burning a lot of cash.
* Interest expenses nearly tripled in the last quarter, though coverage is still well over 5x. Nevertheless, Netflix is spending, perhaps like a drunken sailor, and how fast the content is amortized on the balance sheet and cash flow statement is anyone's guess. This weekend, NFLX released "War Machine" with Brad Pitt. This was a two-hour film. It was supposed to have a limited theatrical release, but Box Office Mojo did not report any theatrical revenue for it. Variety estimated the cost at $60 million. To make a 25% return on the film, Netflix would need to add more than 500,000 subscribers to finance its cost. Of course, this is extreme analysis, but surely Netflix paid the film costs with cash.
* Netflix sells at over 100x trailing 12-month Ebitd. Interest rates are likely rising. When that happened in 1972-1974 (although from a much higher level), price/earnings multiples on the Nifty 50 contracted--at first slowly, then rapidly. This is called financial math. I think it still works.
The proliferation and popularity of ETFs and the dominant impact of machines and algos, which are agnostic to balance sheets, income statements and valuations, clearly have inured to the benefit of FANG and have produced a narrow leadership framework for our markets. But I have learned, after four decades of investing, to be skeptical when new paradigms are so readily embraced.
Financial laws have not been repealed.
While Facebook and Google may well be buys in a market correction, I would avoid both Amazon and Netflix.
As the sign said on the old wooden roller coasters: "Hold on to your hats!"