The top five holdings of the S&P 500 and the NASDAQ 100 indices have generated the bulk of the market's returns in 2017. Increasing fund flows from actively managed to passive index funds has contributed to the market outperformance of these issues and has resulted in concentration risk for index investors as well as investors in the individual stocks. The next bear market or market correction could result in disproportionately large outflows from these stocks.
Investing pundit Jim Cramer initially came up with the acronym FANG a few years ago as a buzzword for four of the most popular and best-performing tech stocks, which consist of Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Alphabet/Google (NASDAQ:GOOG) (NASDAQ:GOOGL). As of June 7, the FANG stocks have accounted for over two-fifth of the Standard & Poor's 500 index market value gains this year.
While the FANG stocks get a lot of media and investor attention, the real driver behind the S&P 500's (SPX) and the NASDAQ 100's (NDX) performance in 2017 has come from the top five holdings of these two indexes, i.e., the FAAMG stocks. This acronym was coined by Goldman Sachs, which dropped NFLX from FANG, as its market cap is too small to have much of an impact on the S&P 500's price movement, and added the mega cap stocks, Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT). As of June 7, the FAAMG stocks have contributed one-third of the S&P 500's gains in 2017.
As the chart below illustrates, the FAAMG stocks account for 13% of SPX by market cap and 42% of NDX. While those weightings are large, even more impressive is that these five FAAMG stocks have accounted for 40% of SPX's year-to-date (YTD) performance and 55% of the NDX's YTD performance. Together, the FAAMG stocks have generated $660 billion in market capitalization in 2017. To put that in perspective, the market capitalization produced YTD in 2017 alone by the FAAMG stocks is equivalent to the entire market cap value of Comcast (NASDAQ:CMCSA), International Business Machines (NYSE:IBM), United Parcel Service (NYSE:UPS), Kroger (NYSE:KR), Boeing (NYSE:BA), and Morgan Stanley (NYSE:MS) combined.
Source: Business Insider
The next chart below shows the outperformance of the individual FAAMG stocks YTD through June 7, as compared to SPX and NDX. Notice that all five FAAMG stocks have delivered double-digit stock price returns compared to the more meager 7.8% return for the SPX. Of the five stocks, MSFT was the only stock whose performance was less than NDX's YTD return.
The FAAMG Stocks Have Beaten the Market, So Why Am I Not An Investor?
To be sure, anyone who invested in FAAMG stocks at the beginning of 2017 (or over the past few years) has done very well in terms of capital gains performance. Despite the recent selloff on Friday and Monday, the stocks have already begun to bounce back on Tuesday, and there is certainly no compelling fundamental reason why these stocks can't continue their march higher over the remainder of the year. While some observers have compared the lofty rise of the FAAMG stocks to the 1990's dot.com tech stocks, the valuations of the FAAMG stocks is nowhere near those extremes, and all of the stocks are earning profits (even AMZN!) and have solid cash balances and cash flows. What's more, the products and services these companies provide are expected to increase in demand.
Nonetheless, I don't have any investments in individual FANG or FAAMG stocks, nor do I have any intentions of initiating a position. But with all the positives listed above and with the terrific market performance YTD, you may be asking why am I not buying any FANG or FAAMG stocks? Below I've provided my top three reasons that I'll pass on investing in any FANG or FAAMG stocks.
Top 3 Reasons I'm Not Buying FANG or FAAMG Stocks
1. I Already Own Enough FANG and FAAMG Stocks
Say what? I just said I don't own any FANG or FAAMG stocks, but now I've apparently changed my tune by stating that I have enough shares already. What gives? Although I like to invest in individual stocks, the truth is that my wife and I own several passive index funds that we've held for years, including the Vanguard S&P 500 Index Fund (MUTF:VFIAX) and the Vanguard Total Stock Market Fund (MUTF:VTSAX). Both of these funds have the FAAMG stocks as their top 5 holdings, and each of course also holds NFLX.
Thus, any investor that holds or actively contributes to a market-cap-weighted passive index fund or ETF that tracks the S&P 500, NASDAQ 100, or other mega-cap weighted index, likely already holds very large percentages of their investments in FAAMG and FANG. So why would one want to buy more of an index's top holdings, particularly if those holdings already account for a disproportionate amount of the recent market performance and the index's overall holdings?
One could argue that you can't have too much of a good thing, but I would counter that, yes, you can have too much of a good thing. And when it comes to the stock market, good things have a way of turning very bad in a hurry. And if one has a highly concentrated position, even via a supposedly diversified index fund, why increase one's risk exposure to more of the same?
Thus, because I already own FANG and FAAMG through my passive index funds, I see no reason to pile on and add even more of these companies to my stock pile. For the record, it should be noted that while my wife and I continue to hold VFIAX and VTSAX, we are no longer contributing to those funds and are putting our money to work elsewhere, as I noted in Investing Strategies for an Aging Bull Market.
2. Passive Index Investing is Causing Further Concentration Risk in FAAMG Stocks
Since I already own a high concentration of the stocks that make up FANG/FAAMG due to my mutual fund holdings, I want to increase my exposure elsewhere in order to reduce my concentration in those specific stocks. One reason for the outsize weighting of FAAMG in SPX and NDX is due to the large increase in investor funds flowing to passive index funds. As the chart below illustrates, some $900 billion has flowed into passive funds since 2009, while investment into actively managed funds has decreased concomitantly.
Source: Business Insider
While it's great that retail investors have recognized that passive index funds have outperformed actively managed funds since the Great Recession, and at a much lower cost, the strategy has the unintended consequence of forcing these cap-weighted funds to invest the largest amount of inflows into the very stocks that have the largest market capitalization. This results in a self-fulfilling prophecy of driving the price and cap values of the largest holdings even higher. While this appears to work great for investors during a bull market, it can actually have the opposite effect during a panic selloff or during a bear market when previous inflows turn into hasty outflows. And those stocks, such as FAAMG, with the largest cap values, are the stocks that are likely to be the hardest hit during a market correction.
Thus, my investment strategy is not to chase after high-flying stocks that have done well in the recent past, but to find high-quality companies that are flying under the radar, but still have potential for solid returns and that aren't as likely to crash as hard during the next big market downturn. There are a multitude of quality large and mid-cap stocks that one can find at relatively decent valuations, and that aren't concentrated in the same tech sector as the FANG/FAAMG stocks. What's more, when the high-flying FAAMG stocks do take a nasty tumble, like they did on June 10 and 12, there was a notable rotation into other sectors of the S&P 500. Thus, diversification outside of the FANG/FAAMG stocks can provide a hedge against a sector sell off or market panic.
3. I'm A Dividend Growth Investor
I primarily consider myself to be a dividend growth investor, and I seek to invest in high-quality stocks (solid financials) that have a strong track record of paying dividends, and that are likely to continue paying dividends for years to come (based on solid earnings and low payout ratios). With the exception of AAPL and MSFT, the FANG/FAAMG stocks don't pay dividends, and thus are mostly off my radar when it comes to consideration of companies to invest in.
It's really as simple as that. While many investors think of investing success in terms of capital appreciation, my definition of investment success is the ability of my investments to provide income in the form of dividends to cover my living expenses once I retire. While I could always sell shares of say, GOOGL or FB to pay my expenses, I prefer to invest in companies that are willing and able to share their profits with investors in the form of cold, hard cash in my hands via regular and increasing dividend payments. While many investors eschew dividend growth investing, the success of the strategy in terms of both providing income and total return performance is well documented.
For example, the chart below illustrates the average annual total returns of S&P 500 stocks from 1972 through 2014 based on a stock's dividend policy. What these data show is that the collection of stocks that initiated a new dividend or raised their existing dividends had greater total returns on average than all other categories. The second best-performing class was the collection of "All Dividend-Paying Stocks" (inclusive of any stock that paid a dividend). The group of dividend-paying stocks that did not increase their dividends performed only slightly worse than a portfolio of equal-weighted S&P 500 stocks. Non-dividend stocks and those that either cut or eliminated their dividends performed the poorest on average over the time frame analyzed.
Source: Ned Davis Research
I recently provided a historical analysis of dividend growth investing and traced the history of dividend-paying stocks back to the year 1602 in an article here.
While there is no doubt that the stocks that make up the FANG and FAAMG acronyms have provided investors with outstanding returns, both YTD, as well as over longer time periods, I have no interest whatsoever in chasing this performance or investing in these companies. Their outsized performance is based, at least in part, on their similarly outsized weightings in the various mega-cap passive index mutual funds and ETFs. And since most investors, including myself, already own such funds, choosing to purchase shares of the individual FANG/FAAMG stocks is redundant and leads to increased concentration risk.
Furthermore, the large and ongoing shift in fund flows from actively managed to passively managed index funds has led to further concentration in FAAMG stocks, particularly for cap-weighted funds. This has resulted in a self-fulfilling prophecy and a dangerous cycle of the majority of investor dollars chasing after the largest stocks in the market, which increases share prices and market shares of those same stocks, and then results in even more money flowing into those same stocks. While this has worked well during the current bull market, these same top holdings of passive index funds will see concomitant outflows of money during the next bear market or correction.
In addition to my aversion of FANG/FAAMG stocks due to concentration risk, only two of the six stocks (AAPL and MSFT) currently pay a dividend, which immediately removes the other four stocks from consideration for me as a dividend growth investor. For investing in individual stocks, my focus is instead on finding high-quality companies that are attractively valued, that have a history of paying dividends, and that are likely to continue doing so in the future. While AAPL and MSFT do pay dividends, the concerns raised previously about their outsized weightings along with increasing fund flows into passive index funds keeps me cautious about these issues.
In summary, long-term investors should be cautious about stocks like those within FANG and FAAMG that have been largely responsible for much of the broader market's YTD gains, and that account for a disproportionate percentage of large-cap passive index fund holdings. While such stocks can continue trading higher for extended periods of time, one should be extremely leery about investing in stocks so heavily represented in broad indexes such as SPX and NDX. This caution has nothing whatsoever to do with the quality of these companies, as each of these six stocks are all well-run, quality-holdings that are deserving of the market's respective weightings. Nonetheless, it is precisely the outsized market weightings and fund flows into these stocks that raise my anxiety level and cause me to look elsewhere for investment opportunities.
Disclosure: I am/we are long VFIAX, VTSAX, VYM, HBI, OHI, CMCSA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.