The FANG stocks are back

If the word “FANG” brings images of Dracula to mind, you’re not alone. Nevertheless, in the world of investments the acronym FANG represents four tech giants: Facebook, Apple, Netflix and Google (now Alphabet). The term has regained popularity this year along with its younger companion FAAMG (Facebook, Apple, Amazon, Microsoft and Google). The reason for its resurgence is directly related to this year’s U.S. equity market performance.

Year-to-date the U.S. stock market – using the S&P 500 index as a proxy – returned nearly 9 percent to investors. The FAAMG companies, the five largest stocks in the S&P 500, represent approximately 13 percent of the index’s market capitalisation but are responsible for nearly 40 percent of that return, according to a Goldman Sachs report. Their contribution to the return of the Nasdaq 100 (Ticker: QQQ) is of greater significance, as they represent almost 40 percent of the index value.

Even more astonishing is the mere size and financial significance of these companies, adding a combined $600 billion in market capitalization this year – a value within striking distance of the GDP of Saudi Arabia. Furthermore, with the exception of Microsoft, all five enterprises have seen their share price soar between 20 percent and 34 percent in the first half of the year.

Why is tech on the rise?

Needless to say, the first-quarter earnings reports for the tech sector were exceptional, with 8 out of 10 tech companies beating analysts’ profit estimates. The sector is also outperforming the broad market by a factor of 2 to 1, posting the highest returns year-to-date. Notwithstanding its reliance on economic growth, the sector exhibits a relatively low correlation with changes in interest rates, inflation and the U.S. dollar. These characteristics bode well for tech for the remainder of the year. Additionally, fundamentals for these tech giants seem solid and only reinforce their strength in a growth environment.

The increased money flow into passive index strategies has further propelled these stocks. The more capital pours into index funds like SPY and QQQ, the higher the demand for shares of FAAMG stocks, increasing prices even further. The higher the valuations, the greater the enticement for investors to jump in for fear of missing the gravy train. It is this type of behavior that has some shouting déjà vu and sounding the dot-com bubble alarm.

Is another tech bubble forming?

A recent analysis by Goldman Sachs argues that the current valuations of FAAMG stocks are far from the extreme levels witnessed during the tech bubble. The investment bank further notes that the five largest firms during the tech boom bubble (MSFT, CSCO, INTC, ORCL & LU) traded at an aggregate forward PE of nearly 60, versus a much more conservative 22 forward PE for today’s big five. The Goldman study also cited today’s tech stocks’ much healthier cash flow metrics and sizable cash balances.

For those who remember the tech bubble, this year’s tech rally may induce an eerie feeling akin to that at the onset of the financial crisis. On the other hand, it is quite possible that these tech stocks are experiencing a changing dynamic with more room to run. The long-term trend for tech appears to be positive, given we are still in the midst of a technological revolution with even more disruption expected from these giants and new market entrants.

Given the tentacles of FAAMG, a position in an index tracker like S&P 500 combined with a position in the Nasdaq 100 and a direct holding in AAPL, for instance, can quickly result in a portfolio highly sensitive to the tech sector. The concentration risk may be much higher than initially thought. As with all investment strategies, it behooves investors not to put all their eggs in one basket.

Sources: Bloomberg LP, Goldman Sachs

The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.