Hell of a week for mega-cap stock earnings in the US. You’ve got 5, trillion+ dollar companies growing at startup type rates. It’s remarkable stuff.
Usually, as a passive investor one of the great things is not needing to have a view on individual stocks, you have the luxury of just shrugging while knowing you have some exposure to almost everything. But sometimes with these stocks it’s different, they are such a large part of the major indices that you almost do have to have a view. At the time of writing Apple, Microsoft, Amazon, Facebook and Google comprised more than one eighth (14%) of the broadest MSCI World Equity index.
Let’s break down some of the week’s earnings announcements stock by stock, I think it’s helpful to learn a litle more about the companies and also put a lie to the idea that this group is “tech”, they really aren’t – the sectors got re-classified in 2018 and yes this does matter, so the first thing is we’ve got to stop thinking about them as being part of the same sector, they do quite different things.
We can review some key stats really quickly with the help of my favourite markets info tool: Koyfin (can you believe it’s free?)
Lot’s to break down from this table, we have: huge market caps ($8.5trn total, massive free cashflow, big growth rates and high margins …
Amazon just reported revenue growth of 44% year-on-year. For one of the highest-revenue companies in history to be growing at that rate is pretty staggering. It’s actually back to growing revenues as fast as it did a decade ago, for a $1trn+ company still to be growing at those rates it’s, well, remarkable (one issue with writing about these stocks is you run out of superlatives pretty quick. For which, apologies).
Like Howard Marks said in his epic Value/Growth memo, very few companies can maintain growth rates like that for a decade or more, but it is extremely hard to value those that do. Of course, Amazon stock has always looked expensive relative to earnings (which are low albeit artificially understated due to intangibles accounting ), but if revenues keep growing like that almost any price can make sense.
Amazon has only recently taken the mantle of the largest retalier in the world from Walmart. A quick look at online retail sales as a proportion of total sales (just about 21% in the US) shows you how early we arguably still are in the online retailing game. Most of Amazon’s stock price derives from cashflows more than a decade in the future (check this out with Aswath Damodaran’s excellent explainer on these companies and accompanying DCF model), but the future is certainly very bright indeed. Amazon isn’t a tech stock- it is the world’s largest, and fastest growing retailer plus a little side biz (AWS) which effectively levies a tax on internet activity that throws off cash like mad.
Facebook is a media company – it sells online ads (in case you weren’t aware!), it turns out business is good in the online ad game and of all the mega-cap firms it prints money like no other. It has gross profit margins of c80% on revenues of almost $100bn.
Facebook actually makes more revenue per user (about $16 per month) than streaming services, but of course it doesn’t pay for content.
Of all the mega-cap stocks Facebook has consistently traded on the lowest price earnings multiple in the last few years, round about a mid-20s multiple. In fact it’s trailing PE ratio today (27.9) is actually well below the average of the S&P 500, it’s almost a value stock, certainly a GARP candiadate. Amazon and Apple have left it in the dust these last couple of years when it comes to share price return. Of course there are reasons for that including regulatory pressures and a lot of powerful enemies in Washington, but remember another of Howard Marks’ takeaways – if you find a company that does the proverbial “printing of money” – and Facebook surely does – it’s cheap at almost any price.
Google kicked off the earnings week and was the first of these stocks to surprise with a report 30%+ year-on-year revenue growth thanks to a booming ad business. Online ads boomed as lockdowns set in, and now seem to be booming as they ease (“heads i win … “).
Both revenue and earnings have grown at 20% p.a. for the last 5 years, couple that with 50%+ gross profit margins and you have a recipe for something else extremely special. Google paid $1.6billion for a video website called YouTube just over a decade ago. It now throws that amount off in revenue every month.
Earnings growth rates like these just break conventional valuation methods and that’s been a big issue over the last decade. As Michael Mauboussin has showed, warranted PE ratios increase exponentially as earnings CAGR goes above about 10% p.a. showing how hard it is to correctly value such companies. PE ratios of 100 are not out of the question if companies grow this fast.
The mighty Apple. the first genuine tech stock that I’ve discussed so far is quite different to the rest of these firms. You can see that by looking at the profit margins and revenue growth, which are both modest, and more in line with a mature 40+ year old company that has been the largest in the world for years now.
However the earnings per share is where it gets interesting (+40% over the last twelve months), the growth rate in EPS is more or less as high as it’s been for a decade.
Apple has continued to surprise on the upside selling more and more iphones every time sceptics think the market is saturated, as well as generating more and more sales from wider services. The numbers just get silly but many of Apple’s core channels saw revenue increases of 50% or more compared to the same quarter last year. Use of spare cash for share buybacks have pushed EPS higher. Apple stock has clearly been dramaticaly re-rated by the market from the days of 2016 where it traded on a “widget makers” price earnings ratio that prompted legendary quality/value investor Warren Buffet to invest, a trade that has now made him over $100bn. Anyone who thinks that Apple, now valued at over $2trn has peaked would do well to reflect on the fact that Buffet remains invested, in fact he’s admitted that selling a little in 2020 was probably a mistake. It’s a vast valuation for sure, but the company seems to be doing a pretty decent job of growing into it, so far.
My main pushback against any dot-com era comparisons is that Apple is not Cisco (which briefly became the most valuable company in the world at the height of the boom). You can’t compare. Fun fact: Cisco stock is in a 20 year bear market but has still outperformed Apple over 30 years which just shows you what a wild time the late-90’s era was.
The other tech stock in this quintet has benefited massively from a move to the cloud, to state the by-now blindingly obvious. Microsoft is actually growing faster now, and with higher margins as a near two-trillion dollar business than it was two decades ago as a hundred-billion dollar business. That’s earnings growth which annualises at 30% over 5 years with 40%+ net profit margins. Microsoft also fell into the quality/value basket as recently as 2014 and has been a perrenial top holding of Terry Smith’s eponymous quality-focsued fund.
These latest earnings aren’t a continuation of the work-from-home trade winners. These 5 stocks are all up around their highs, whereas the true work from home stocks like Peloton and Zoom are around 40% down from the levels they reached last summer.
It’s also worth remembering that the recent stock market gains since the vaccine and US-election news late last year has not been driven by these mega-caps, year-to-date returns have still been led by value, mid -cap stocks like banks and energy. Non-US and emerging market stocks have all risen slightly ahead of the Nasdaq index since the start of the year.
Rates, regulation, competition and scale
These are typically the four challenges I see commonly cited to these stocks and there’s a case for each, but none seem to be seriously affecting them so far:
Many people (myself included) wrote that the soaring stock market of summer 2020 owed as much to the ultra low rate envionment in the US where the 10-year interest rate fell as low as 0.6%. However this year the benchmark rate has nudged as high as 1.8% and these mega-cap stocks have barely missed a beat.
Many sceptics of these mega-cap stocks start by raging against the Fed creating an era of easy-money and cheap capital that has artificially pushed prices to the moon. There may be some truth in that but remember that these 5 stocks have very little need for debt. They throw off cash like crazy and tend to have very high levels of return on capital employed. If they were gorging on cheap debt to fund growth I might have more time for that argument, but they aren’t.
At some point surely rising rates will have an impact on discounted cash flow valuations but the previous increasing-rates cycle of 2018-19 peaked out at around 3% on the 10 year and the Fed doesn’t seem to be making any indication of rising rates anytime soon. One lesson I’ve learnt from 20 years in this business is that trying to make macro interest-rate calls has to be one of the worst risk/return propositions there is. Abruptly rising rates could play havoc with all sorts of sectors of the stock market and has to remain a risk.
The contrasting fortunes of smaller digital media companies like Twitter and Pinterest this earnings season is perhaps helpful here. Maybe this really is a winner-take-all type game where rather than eventually getting chased down and overtaken by competition, as we’d expect in a normal competitive world, these mega-companies are going to zoom every further ahead with scale being a key advantage rather than a hindrance.
Finally regulation, which has been hanging over most of these stocks for years now. I’m far from an expert on how this could affect them so I won’t try and make too much comment, other than that the issues are quite stock specific and vary a lot across the five. It didn’t work out too badly for Microsoft following it’s brush with antitrust in the early-2000’s. I even think that a forced break-up of some of these firms wouldn’t even slow them down as much as people think and could even unlock new demand for their stocks as standalone companies (eg youtube or AWS).
Today’s cohort of mega-cap stocks has something special about them that has rarely, if ever been seen before in stock markets. What makes things difficult for investors – perhaps even a paradox – is that these are simultaneously huge and mature businesses, but fiendishly difficult to value for the reasons described above.
If these companies are hard to value – and I think they are – then it makes sense that they will sometimes be over, and sometimes under-valued, but the issue is you probably only know this in hindsight. Lots of the usual mental models and indicators (eg price / earnings) have been broken or found wanting already. So we resort to generalisations and narratives, which is a dangerous game. It can become a sort of Rorsach test where everyone sees what they want in them, ignoring what’s actually going on.
The most obvious and available narrative has been the dot-com era. One reason why I push back against comparisons with the dot-com era is the undisputed way today’s stocks are “winning” in the real economy and surprising expectations year after year today.
Another narrative line is advanced by crude grouping like FAANG , or FANMAG. Even a basic exploration like this piece shows you how different these stocks are, crudely grouping them together isn’t going to lead you to a helpful analysis.
My conclusion from the large-but-hard-to-value paradox is to resort back to passive allocations and a shrug -the-shoulders approach. Less intellectually satisfying perhaps but fairly likely to work over the long term whereas making allocations decisions on valuation views and narratives is a pretty risky game with low return to risk payoff. Not to mention exhausting – you’ve got to take 5 different views , and constantly update your thesis through time with new data (something that sceptics have consistently failed to do). It might work for you, but I’d spend your time and effort elsewhere.
My second perhaps counter-intuitive conclusion is that these stocks could even be under-owned today. Can they keep growing to the moon? No. But everyone would be wise to remember the takeaway’s of Howard Marks’ excellent note. Not every company will enjoy the level of success priced into these stocks. But it’s very hard to correctly value those that do.