In 2007, the finance sector in the S&P500 is the largest sector constituting 18% of the index.
Technology companies were a close second at 17%.
10 years later, the tables have turned, tech companies have overtaken financials by a wide margin -- a quarter of S&P500.
Here are some interesting facts:
These numbers are poised for greater growth as the FANG companies penetrate more markets and introduce a bigger ecosystem of products and services.
FANG companies are listed and you too can participate in their growth. If you cannot beat them, join them!
In this article we will assess FANG stocks using our Gross Profitability Asset Dividend (GPAD) strategy. You can read more about the strategy in our Factor-Based Investing Guide.
All four FANG stocks close their books on the 31st December of each year. This allows us an identical timeframe to compare their performances against.
Amazon came out tops with a 50% Gross Profitability. Facebook is in second place with 42%. In 2017, these two companies produced higher gross profits while utilising proportionately lesser assets compared to Netflix and Google.
^ Data based on annual reports as at 31-Dec-17
None of the FANG stocks distributed dividends. The quartet remains focused on growth and all earnings are retained and reinvested into the business.
Hence, we would be missing a crucial valuation metric which will help us determine which is the cheaper company to purchase.
This also means that today’s article will focus on determining the highest quality company amongst the four and we will not make any comment as to whether the stock prices are fair or not.
Average Free Cash Flow Yield
Losses do not kill companies. It is cash flow (or rather, the lack of cash flow) that does. It is important to examine the cash flow of any company before you invest.
One of the most stringent ways to evaluate cash flow is to use the Free Cash Flow (FCF) metric. It is a measure of how much cash a company generates after accounting for capital expenditure such as buildings and equipment. However, FCF is a highly volatile number because the capital expenditure (CAPEX) may happen in some years but not others. Large CAPEX may result in very low FCF in that particular year. In years where CAPEX is low, the FCF would be too optimistic. Thus we will average the FCF over a period of five years to smooth out the irregular CAPEX impact.
We converted average FCF into per share value and compared it with the corresponding share price. In comparison, Alphabet produces the highest FCF yield of 5% and Netflix was the worst with -1%. This means that Netflix is still spending more cash than they could generate from the business.
Based on the numbers so far, Facebook and Amazon are the better stocks to invest in. Netflix is the weakest of the lot. I have always wondered how Netflix arrived on the same pedestal as the other 3 tech giants. To me, it is in a totally different league. Apple would be a better option than Netflix.
Qualitative Analysis of the Business
Facebook – The funny thing I realised is that even the most technologically advanced companies in the world make money conventionally. For Facebook, besides touting their Virtual Reality technology, they still make most (if not all) of their money from good ol’ advertising.
In 2017 Facebook made about $40 billion from advertising. Only $711 million was derived from developers using their payment infrastructure as well as for the delivery of virtual reality platform devices and various other sources.
The current Facebook advertising model is a threat to traditional media (newspaper, magazine, TV, radio etc). Many publishers and broadcasters have seen their revenue take a big hit.
According to media agency Zenith, global advertising spend is expected to be $578 billion in 2018. Currently Facebook is only doing about $40 billion, or 7% market share. Facebook’s ad revenue has been grown 49% between 2016 to 2017 and if this rate of growth is an indication, Facebook is well positioned to capture an even larger share of the pie. On top of that, this pie is set to expand as more and more media agencies turn to digital advertising in order to remain relevant.
The number of users on Facebook determines the value of its advertising business. To continue growing, Facebook needs to retain the current pool of active users, attract new ones, and also get users to spend more time on the platform.
Facebook has been upgrading the platform as well as introducing new features such as Stories and Stores. They have also acquired Whatsapp and Instagram. We can view these acquisitions as buying out competitors, buying more users and creating synergies with complimentary products. The strategy involves expanding the suite of things one can do on Facebook in the hope that each user will stay in the ecosystem longer and be more active.
As Facebook gathers more user data, they could deliver the ads better and help businesses target their customers much more accurately. This would make Facebook indispensable to businesses because of the superior ROI they can promise compared to other platforms (at this moment only Google matches up as a close rival).
And because Facebook has a trove of user data, other organisations would also want to have a peek into it. The Cambridge Analytica scandal and the likes of it will happen from time to time. Such incidents will test the level of users’ dependency on Facebook and how much they are willing to remain engaged at the risk of having their privacy compromised. So far, most users do not seem to care enough about it and Facebook has not taken any hit in terms of ad revenue. Most users are still willingly divulging their information in exchange for Facebook services.
At the current moment, my view is that Facebook will continue to grow its dominance in the social media space and digital advertising business.
Amazon – Amazon, on the other hand, is not dependent on advertising. Even though their revenue is more diversified, up to 79% of the total is still derived from ecommerce (61% online stores and 18% third-party seller services). The next major and growing segment is the Amazon Web Services (AWS), contributing 10% of the revenue in 2017.
AWS has been a wild success with many enterprises using it as the default option for cloud computing services. Google has also ventured into this space with Google Cloud but it is still playing catch up with Amazon. As the world moves into Big Data and Artificial Intelligence, the demand for cloud computing services is set to grow.
Subscription services mainly refer to Amazon Prime membership, currently contributing $4.5 billion or 5% to the revenue. This allows the members to access the largest ebook library in the world and other digital media content such as videos (a much lesser competitor to Netflix) and music (a much lesser competitor to Spotify). Members may also get other benefits like expedited deliveries of their online orders.
Amazon have also started to have physical stores known as Amazon Go. These stores pride themselves as the most technologically advanced in the world. There is no need for customers to checkout – just walk into the store, pick what you want, pack and just walk out. Watch the video if you have not done so already.
Besides diversifying into different businesses, Amazon is also expanding geographically. Prime is in Singapore shores now and yours truly has been a regular customer ordering necessities and getting them delivered to the house. Another often overlooked aspect of Amazon is that they have been building up their logistics and fulfilment capabilities. The way they arrange their warehouse looks messy to most people but it is actually the most efficient way according to Amazon.
Given the diversified nature of the business, it seems like Amazon is fighting on many fronts. Amazon is up against Alibaba in ecommerce, Google in cloud computing, Netflix in videos, and Wal-Mart in supermarkets. Can one company be good in all areas at the same time? Only time will tell.
Netflix – Weakest of the FANG. The Netflix business model is simple – maintain a digital library of the widest range of movies, documentaries and TV series and sell monthly subscription. Unlike physical movie rental stores, Netflix is not limited by shelf space, expensive real estate nor geographical reach.
Even though most of the revenue still comes from the U.S., Netflix today has a growing international streaming business segment. However, due to film distribution rights in various countries, the vast library of film content is not always fully available to the users. The attractiveness of Netflix is highly dependent on the number of films a typical user is keen to watch. The more time people spend watching TV or movies, the more successful Netflix becomes. To become even more successful, Netflix will have to work on increasing the access as well as growing the library.
In 2012, Netflix moved into producing its own content. Netflix productions are available only on the Netflix platform. Moving onto exclusive content is a natural progression as it creates a differentiating factor between Netflix and other providers. While a user is able to watch ‘Mission:Impossible” on Netflix and any other streaming platform, he can only access a Netflix blockbuster on Netflix itself.
Netflix has exclusivity for House of Cards, The Crown and Black Mirror. Here is the list of Netflix’s originals.
In comparison, HBO has exclusivity for Game of Thrones, Westworld and Silicon Valley. You can find a list of originals here. Amazon Prime has originals too but I do not see any blockbusters. The full list here.
Other companies like Hulu (a joint venture among Disney, Fox, Comcast and Time Warner) invest lesser in original content. HOOQ (Sony Pictures, Warner Bros and Singtel) has also launched their original series with a focus on Asian production.
Among the online streaming service providers, Netflix is reportedly spending the most in the production and acquisition of content with a $8 billion budget in 2018. I believe Netflix’s edge comes from their scale. To succeed, they will have to continue to grow the library and produce irresistible exclusive content.
While many critics have blasted them for spending more and more on content production, I for one believe that they should not scale down on that. They simply cannot afford to.
Alphabet (Google) – Google started off as a search engine. It went on to become the best at helping people locate information on the web. It then branched out into advertising and in the process, discovered that helping advertisers find customers was their forte too. They now rake in billions of dollars of advertising revenue each year.
86% of Google’s revenue in 2017 came from advertising while 13% come from a myriad of other Google products such as sales of apps, in-app purchases, digital content products, hardware (I love Chromecast!) and Google Cloud offerings. As little as 1% of the revenue was contributed by Other Bets – these revenue were derived primarily through the sales of internet and TV services through Fiber, sale of Nest products and services, and licensing and R&D services through Verily.
Similar to Facebook, Google is innovating and expanding the repertoire of services to keep you within the Google ecosystem. Taking stock of my life, here is a scary long list of my association with Google.
- Gmail – I use it almost exclusively, personally and for business. I use it every day.
- Google Calendar – I cannot live without this in my life.
- Google Keep – I use this as a to-do list as well as to record my thoughts on the go.
- Google Maps – GPS on the phone is a godsend. I use it in Singapore and even more so overseas.
- Google Drive – A cloud storage and document processing tool (Sheets especially) which I use regularly besides Dropbox and Microsoft Office.
- Google Photos – Previously I used Flickr but I switched to this because it is a lot easier to archive and safe-keep my photos.
- Android OS – I use an iPhone but my tablet runs on Android. 87% of the global mobile operating system market share belongs to Android! If this is still not world domination, I do not know what is.
- Chromecast – I use this to project videos on the TV from my phone.
- Google Trip – I used this to plan for my last trip to Europe.
- YouTube – enuff said.
So Google knows a big deal about me. It knows where I frequent, who I meet, how they look like, what my thoughts are, what I like, or maybe even habits I did not know about myself. Google knows more about me than I do. And it is scary but I cannot stop using their services. In fact, I switch to Gmail and Google Photos from Yahoo! Mail and Flickr. I became more entrenched in the Google ecosystem over time.
The more Google knows about me, the more they can use my data to help advertisers target me. I would be more likely to buy something from the advertisers because I generally have an interest in their products and services. They may also catch me at the right time where I would be more open to opening my wallet and clicking buy.
Google is too good at this and I think it is too difficult to get out of their ecosystem. The advertising dollars will keep coming.
Skin in the Game
Besides analysing the businesses in the previous section, we also need to evaluate the people who are driving the businesses. Action speaks louder than words and hence we will look at two things – ownership levels in the companies they run, and if the companies remain founder-led.
Facebook – Mark Zuckerberg is 34 years old (born 1984) and he is the youngest Chief Executive among the FANG companies. He owns about 15% of Facebook but has 60% of the voting rights. This is because most of his shares are Class B whereby each share is worth 10 voting rights as compared to a Class A share of 1 vote per share. Class B shares are not traded and hence there is no way a shareholder activist can collect enough ownership to oust him.
Zuckerberg retains control of Facebook even though he is not a majority shareholder. He has been the main person leading Facebook since he started it in his dorm room. No one would doubt his attachment to the company and it could only increase with time. His monetary attachment to Facebook on the other hand has been decreasing; he has been selling his shares and has even pledged a fair bit of them to philanthropy. Zuckerberg’s wealth and legacy is tied to Facebook and I do not see him abdicating his position at Facebook anytime soon.
Amazon – Jeff Bezos is the richest man in the world at $112 billion, all thanks to the ownership and the price of Amazon shares. He owns about 16% of the shares. Unlike Zuckerberg in Facebook, Bezos does not have the majority voting rights in Amazon. However, it would be too difficult and costly for someone else to accumulate more shares than Jeff Bezos. I prefer such an arrangement whereby the founder’s wealth is tied to the well-being of the company. This ensures more alignment with the rest of the shareholders. It is also less complicated than the dual-class shares structure. Jeff Bezos’s salary has been low compared to the value of the company. He has been taking home about $1.7m a year in the past 3 years (Zuckerberg took home about $9m in 2017). This gives shareholders some assurance that his focus is not about the money he makes but the company he is building. Started in 1994, Amazon has been around for 24 years. Relatively older than Zuckerberg at 54 (born 1964), Bezos probably has another 10 to 20 years to run Amazon.
Netflix – Founded by Reed Hastings and Marc Randolph in 1997. Randolph was the first CEO but left in 2002 with Hastings taking over the role. Hastings is 57 years old (born 1960) and has less than 3% ownership in Netflix. This is too little skin in the game for me. In addition, Hastings also does not have majority voting rights like Zuckerberg. The good thing is that he draws a relatively low pay of $850k and stock options worth $21m in 2017. His shareholdings can increase overtime if he exercises the options but it will take a long while.
Alphabet (Google) – Larry Page and Sergey Brin are the founders of Google and both of them are still involved in the company today. Alphabet has 3 classes of shares. Similar to Facebook, Alphabet Class A entitles 1 vote while Class B has 10x the voting power than A. Class C has zero voting power. Larry Page and Segey Brin have about close to 6% ownership of Alphabet (I counted A and B shares only but it is not clear how many C shares they own, if any) but have 51% of the voting power.
It is therefore quite prevalent for founders of large successful companies to have a small fraction of ownership in the companies they founded. This is the reason why they floated the company in the first place. The listing provides the funding that will help grow the business. But to retain control they issue Class B shares that have super-voting rights. We should see this as a good sign that the founders still care about the companies and want to make sure they have the power to do things they want. But of course it comes with risk that they can still mismanage or misdirect the companies.
Come to think of it, I am using services from all FANG companies!
FANG services have become part of our daily lives and FANG companies have become pillars of our modern economy. Despite privacy and security concerns, the adoption of FANG services will only increase
Many funds have invested in FANG stocks. Given that the tech sector makes up a quarter of the market, index funds and funds that want to achieve performance benchmarks in line with market expectations will inevitably have to own FANG stocks.
From an investment perspective, we discovered that Facebook and Amazon are the better stocks because of their relatively high Gross Profitability. Qualitatively, each FANG company exhibit a dominance in their niche. This is hardly surprising given their explosive growth.
We particularly like Amazon because Jeff Bezos has the highest economic benefit vested in Amazon. His ownership in the company he founded is highest at 16% compared to the rest of the FANG founders. Amazon’s revenue streams are also more diversified giving the company a level of robustness unlike the others.
As indicated early on in the article, we are unable to derive a valuation for each of the FANG stocks. Even though Amazon stood out from the rest, it does not mean it is a worthy investment at this current price. As always, do your own due diligence.
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