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Tech watch: Could the FANG stocks be losing their bite?
Will Craig
Equity Investment Analyst

The FANG (Facebook, Amazon, Netflix, Google) stocks appear overvalued to many investors. Not necessarily, says investment analyst Will Craig, who points to reasons why he thinks the internet sector has room to run.


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Matt Miller: Now there are, really, household names in the internet space — the folks that you cover: Amazon, Google, Apple, Facebook, Netflix. One thing that some observers say they all have in common now is high valuations. So let me ask you the question that’s on a lot of people’s minds: Are these companies overvalued, or do the fundamentals support these kind of P/E ratios?

Will Craig: Let me take that from kind of two angles. Holistically, I would say I think the sector, on a long-term basis, remains attractively valued. And I will be surprised if over, call it, a five-year-plus time horizon, the internet doesn’t continue to outperform other sectors within the S&P 500.

Within the sector, I would say that the valuations of some of those companies you mentioned are very, very different. For instance, Apple — I actually don’t cover Apple — but it actually trades at a below-market earnings multiple the last time I looked. Whereas Netflix doesn’t even generate earnings or cash flow, and so by traditional metrics it looks extremely expensive.

So I think it depends a lot on the company you are talking about. But overall, I remain optimistic about the internet’s prospects.

Matt Miller: Now is there — and I should mention, when we talk about specific company names, we’re talking generally about how you might view them. It’s not a buy or sell recommendation . . .

Will Craig: Yeah.

Matt Miller: . . . which is not something that we’d be doing here. When you look at the potential for higher earnings growth down the road for these firms, where can it come from? Some people will say that already a third of the world’s population is on Facebook. How much more growth can reasonably be assumed, and does it differ by company? How do you think about that?

Will Craig: Well, I think Facebook would say that that’s their opportunity to triple their user base. And I think their vision is to ultimately —

Matt Miller: To every human on the planet, right?

Will Craig: Yeah. They want to build a directory of the world, and they want to build the globe’s social network. I don’t know if they can get everyone on, most notably because they’re not in China right now because of regulatory reasons. But I think they’re on a clear glide path — if you look out five years plus — to have 5 billion or more users. So you’re talking about more than doubling their user base.

And I would say just at the most fundamental level, the biggest tailwind I see for the internet stocks is that still only half of the 7 billion people around the world have ever been online. And over the next several years, we’re going to get very, very close to 100% penetration.

Matt Miller: Globally?

Will Craig: Globally. We won’t get there, but should get up to certainly 80% plus, maybe even 90% plus, most notably because increasingly affordable smartphones are literally putting computers in the pockets of billions of consumers around the world.

Matt Miller: Maybe we should step back for a second, because the potential scale of these internet businesses is so different than anything we’ve seen, really, in business and society before. How do you think about that as an investment analyst, as you help make decisions for our team?

Will Craig: First I would say these are extraordinary businesses. And I think only the last few years that’s really — even within the investment community — has been fully appreciated: just the network effects; the self-reinforcing flywheels that are powering some of these businesses; the fact that, in many cases, their incremental margins are effectively 100% —

 Matt Miller: And that’s because adding an extra user involves virtually no variable costs?

Will Craig: Exactly. If you’re Google or Facebook, to serve an incremental add, literally the only cost of that add is the infinitesimal cost of the incremental server utilization necessary to process that click. They build out these fixed-cost platforms, and then all the revenue on top just falls straight to the bottom line.

And so they have a lot of software elements in that sense. One of the great things that made software such a good business is how high the incremental margins are, because the incremental cost of a digital widget is negligible, whereas in traditional industries there’s always been very significant variable costs in raw materials and whatnot.

So I think that combination of larger addressable market plus nearly 100% incremental margins — and then, I think, the final thing is maybe some of the network effects and flywheels that make it . . . I mean, good luck trying to displace Google at this point or trying to displace Facebook.

 


 



Will Craig covers U.S. small- and mid-cap companies as an equity investment analyst. He has 13 years of experience and holds an MBA from Stanford and a bachelo's in Asian studies from the University of North Carolina. 


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