First Trust Dow Jones Internet Index ETF: Rapid Growth Should Continue

|
About: First Trust DJ Internet Index ETF (FDN), Includes: AMZN, CRM, EBAY, EXPE, FB, GOOG, GOOGL, NFLX, PYPL, TWTR
by: Ploutos Investing
Summary

FDN invests in large and giant-cap Internet stocks in the United States.

Stocks in FDN’s portfolio have competitive positions over its peers.

FDN will benefit from several secular growth trends such as growth in e-commerce sales, rising online advertising spending, and increasing time spend online.

The ETF is trading at a slight premium to its historical average.

ETF Overview

First Trust Dow Jones Internet Index ETF (FDN) owns a portfolio of mostly large-cap and giant-cap Internet stocks in the United States. The fund tracks the Dow Jones Internet Composite Index. Most of these large and giant-cap stocks in FDN's portfolio have competitive positions over their smaller peers. We expect companies in FDN's portfolio to benefit from growing e-commerce sales, rising online advertising spending, and increasing time spent online. Although its shares may be slightly expensive, we think long-term investors can continue to invest and add shares on any pullbacks.

Chart Data by YCharts

Fund Analysis

Mostly large and giant-cap companies with competitive positions

As the table below shows, nearly 60% of FDN's portfolio consists of large-cap or giant-cap stocks. These are companies that are well-established and have the cash to spend on R&D and marketing to maintain its competitive advantage over its small peers.

Source: Morningstar

In fact, FDN's top 10 holdings are companies with moats. As can be seen from the table below, all of the top 10 holdings, except Twitter (TWTR), receive narrow or wide moat status, according to Morningstar's research. These top 10 stocks represent about 54% of its total portfolio. Most of these stocks have products or services that are very sticky to their customers (e.g. Amazon's (AMZN) Prime membership, Facebook's (FB) social networking website, Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) services). Therefore, these Internet companies should continue to attract customers and crowds to their websites.

as of 08/27/2019

Morningstar Moat Status

% of ETF

Amazon (AMZN)

Wide

9.90%

Facebook (FB)

Wide

8.39%

Salesforce.com (CRM)

Wide

5.46%

Alphabet Class C (GOOG)

Wide

5.28%

Alphabet Class A (GOOGL)

Wide

5.17%

PayPal Holdings (PYPL)

Narrow

5.07%

Netflix (NFLX)

Narrow

4.66%

Twitter (TWTR)

None

3.77%

eBay Inc. (EBAY)

Narrow

3.44%

Expedia Group (EXPE)

Narrow

2.98%

Total:

54.12%

Source: Created by author

FDN is a good way to benefit from increasing Internet usages

Companies in FDN's portfolio should continue to grow at a fast pace and benefit from the trends of growing e-commerce sales, rising online advertising spending, and increasing time spent online.

Many stocks in FDN's portfolio such as Amazon, PayPal, and eBay should benefit from increasing e-commerce sales. As can be seen from the chart below, retail e-commerce sales worldwide are expected to grow from $3.54 trillion in 2019 to $6.5 trillion in 2023. This is a growth rate of 85% in 4 years.

Source: Statista.com

Companies such as Facebook and Google in FDN's portfolio will also benefit from rising digital ad spending. As can be seen from the chart below, worldwide digital ad spending is expected to grow from $283.35 billion in 2018 to $517.51 billion in 2023. This will be a growth rate of 83% in 5 years. By 2023, digital ad spending will represent over 60% of the total media ad spending.

Source: eMarketer.com

FDN is trading at a premium already

FDN has delivered an excellent total return of 541% in the past 10 years. This is much better than the S&P 500 Index's total return of 240%. As can be seen from the table below, FDN's forward P/E ratio and price to cash flow ratio are all much higher than the S&P 500 Index.

as of 9/9/2019

FDN

S&P 500 Index

Forward P/E Ratio

27.51x

17.88x

Price to Cash Flow Ratio

14.75x

9.21x

Sales Growth (%)

13.44%

7.09%

Cash Flow Growth (%)

16.07%

13.25%

Source: Morningstar, Created by author

Now, we will compare the valuation of the top 10 holdings in FDN's portfolio with their own historical average. Since many Internet companies will sacrifice short-term earnings in order to grow sales, P/E ratio will not be the best metric to use. Instead, we will compare these companies' current price to sales ratio to their historical averages. As can be seen from the table below, these companies' weighted average price to sales ratio of 7.06x is slightly higher than their 5-year average of 6.35x. Therefore, we think these companies are trading at a slight premium to their historical average.

as of 9/9/2019

Price/Sales

5-Year P/S

% of ETF

Amazon (AMZN)

3.65

3.16

9.90%

Facebook (FB)

8.71

14.35

8.39%

Salesforce.com (CRM)

8.03

7.92

5.46%

Alphabet Class C (GOOG)

5.70

6.30

5.28%

Alphabet Class A (GOOGL)

5.70

6.41

5.17%

PayPal Holdings (PYPL)

7.69

5.92

5.07%

Netflix (NFLX)

7.54

7.79

4.66%

Twitter (TWTR)

10.46

9.40

3.77%

eBay Inc. (EBAY)

3.53

3.66

3.44%

Expedia Group (EXPE)

1.73

2.09

2.98%

Weighted Average

7.06

6.35

54.12%

Source: Created by author

Risks and Challenges

A concentrated portfolio

FDN has a concentrated portfolio. In fact, the portfolio only holds 40 companies. The "FANG" stocks represent a significant portion of the portfolio (Facebook, Amazon, Netflix, and Google represent 33.4% of FDN's portfolio). Therefore, there is a significant concentration risk. This concentration can introduce considerable risk, especially if one or two FANG stocks perform poorly.

Economic recession

An economic recession can result in a significant decline in revenues as consumers cut their spending on e-commerce and companies reduce their Internet ad spending. In addition, negative market sentiment in an economic downturn may result in valuation contraction since most stocks in FDN's portfolio appear to be trading at a premium valuation already.

Investor Takeaway

FDN is a good vehicle to participate in the growth of these Internet companies. If you are a short-term investor, its current valuation may be slightly expensive. However, if you are an investor with a long-term investment horizon, we think its shares are not particularly expensive, especially considering the strong growth potential these stocks in FDN's portfolio have.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.