Market Commentary July 2018Submitted by Mark Smith-Windsor Investment Advisor on July 20th, 2018
Value, Growth and FANG Stocks.
Value investing is a style of investing initially espoused by Benjamin Graham, beginning in the great depression. If you haven’t heard of Benjamin Graham that’s okay, he’s dead. What’s important to know about him, is that he was the mentor to Warren Buffett, the world’s richest investor. Buffett made all of his early money following Benjamin Graham’s value investing techniques in the 50’s and 60’s.
The basic philosophy of value investing is that all else equal you should buy companies that trade at low multiples of their earnings or book value and focus less on future growth projections to justify the price paid. Growth Investing on the other hand focuses on future growth as the primary concern, with less care paid to the current price. Amazon is a classic growth stock. Amazon doesn’t earn much to justify its price, but has phenomenal growth potential. Over time a number of studies have shown that on average as a group, growth shares tend to disappoint when compared to value shares.[i]
The only problem, is that this hasn’t been true for a decade. In the last 10 years, growth stocks have absolutely trounced value shares. High growth shares, specifically the FANG stocks (FANG stands for Facebook, Amazon, Netflix and Google)
and their like have been anointed as a special class of share for which normal metrics and financial gravity does not apply. These are fantastic companies, and the bigger bubble is probably in private venture capital back shares.
The question is how much fun is left for these companies? Three of the four are media companies; Google and Facebook are advertising based, and Netflix is a subscription based service. Advertising is a somewhat cyclical business, so there is a point at which these companies should be valued like normal media companies not growth shares.
According to eMarketer, digital ad spending is about 44% of total media spending, and now surpasses television. Of the remaining market, 40% is television and 16% covers newspapers, magazines, billboards, and those ads in front of urinals. I think it’s fair to assume that television goes 100% digital along with newspapers but bill boards will remain. I suspect that digital advertising market share might double in size from here, and at that point grow with the economy at a normalized rate of advertising growth which is about 4 percent.
What would this mean for stocks like Google and Facebook?
Assuming traditional television goes away over the next 7 to 10 years, what does this imply for the growth profile of Facebook and Google? Well, Netflix as far as I can tell, doesn’t have commercials, and it’s unlikely that Facebook and Google take the entire video ad market as they did with print. There is serious competition from Netflix, Amazon, and some of the incumbent media owners like Disney. My thinking is that their advertising revenues, at best, double over the next 7 to 10 years. This translates into a 7% to 10% annualized growth rate and declines from then on.
So what does this imply for the shares? Currently Facebook and Google both trade at about 30 times earnings, which is not a crazy high P/E ratio for growth shares, but when growth companies are no longer high growth businesses they typically experience a reduction in their value as a multiple of earnings. At 5% growth these companies probably deserve a P/E ratio of 20 not 30.
For Google (Alphabet is the parent holding company) this means 80 dollars per share in earnings 7 to 10 years out and a $1600 stock price. This works out to 3% to 4% rate of return assuming everything goes right. Of course, there’s always a risk that everything doesn’t go as planned.
As always I am available for any questions financial or otherwise at 306-385-6261 or by email firstname.lastname@example.org
[i] Comparing the results of value and growth stock market indexes, https://www.fidelity.com/learning-center/trading-investing/trading/value-investing-vs-growth-investing