- Earnings aren't that important but revenue and customer growth is essential.
- The business has to have the capacity to grow without issuing stocks.
- Timing is everything with growth stocks.
"FANG" is the name that has been given to the elite group of technology stocks that includes Facebook, Amazon, Netflix and Google.
These magnificent 4 have delivered astonishing growth. Since its IPO, Amazon has returned 52,491% (yes, you read that correctly) to shareholders. The other three haven't quite been that extreme, but have still seen incredible growth, with Netflix returning 9,198% since its IPO, Google returning 1,429%, and Facebook 338%.
What's especially fascinating is that a big part of those results have come in the last 5 years when each of the FANG stocks were already known globally.
Figure 1: FANG performance in the last 5 years. Source: Yahoo Finance.
This article will investigate the factors that influenced such returns and will try to find patterns that will enable us to recognize a future FANG-like stock when we stumble upon one.
The primary factor behind the amazing returns for each of these companies is growth. Each of the FANG companies have seen their revenue more than double in the last 5 years, with Facebook increasing revenue more than 6 times.
Table 1: Revenue growth (in millions). Source: Morningstar.
So revenue growth is essential, but this revenue growth doesn't necessarily translate into earnings growth. Amazon's revenue grew at a slightly faster rate than earnings, Facebook's are not comparable to Amazon's but the growth is significant, Netflix's earnings growth is still slow and Google's earnings growth is also slower than its revenue growth.
Table 2: Earnings growth. Source: Morningstar.
So we know earnings aren't that important, they don't necessarily even have to grow, as is the case for Netflix. As earnings aren't that important, what is important is customer growth as it shows the potential these companies have which should or could turn in to profits in the future.
The numbers that are even more astonishing than the revenue growth numbers are the number of active users. Amazon had 244 million active users in 2014 and has grown to the 305 million it sees currently, Facebook has 1.7 billion monthly active users, Netflix has 83 million subscribers and Gmail users have reached a billion.
Figure 2: Gmail users. Source: Statista.
The conclusion is pretty simple: we need to look at a business that is on the brink of profitability which eliminates the needs for capital raises as none of the FANG stocks have had significantly dilutive stock issuances in the last 10 years (FB since IPO). Businesses need to show stellar growth in customer numbers which means they are a simple product to use, better than their competition and set up in a way that can be scaled globally as the potential is what pushes the stock price up.
There is always a risk that something happens in the business model, but the FANG stocks show that you don't have to invest in the latest hot stock or product. You can wait until the player becomes a global leader and then invest. The amazing returns from figure 1 were achieved even though the companies were already global leaders in their respective fields.
The second risk lies in the fundamentals. Google has a current PE ratio of 30.2, Facebook's is 62.1, Amazon's is 196.2 and Netflix's is 312.8. The ratios weren't better 5 years ago, with the exception of Netflix who had two bumper years in 2011 and 2012 when the PE ratio fell to 15.7.
Figure 3: Netflix 2011 troubles. Source: Yahoo Finance.
Amazon also provided great investment opportunities when its PE ratio was below 100 in the period from 2006 to 2011. In any case, the better the valuation a growth company has, the less risk you run.
The third risk is volatility. As in the above figure, 25% moves up and down is something that should be expected. Any kind of disappointing news creates a selling spree as the companies have no fundamentals to limit the damage. On the other hand, the growth, which is unrelated to economic circumstances, makes such companies a good play in times of economic turmoil. All FANG stocks fell during the 2009 crisis but as soon as liquidity returned, they quickly rebounded and returned to growth.
Figure 4: FANG stocks during crisis. Source: Yahoo Finance.
Another risk is that the management is not yet that competent except for the huge leverage they get from their growth. We have plenty of examples for this, examples like the Fire phone that was a flop for Amazon, or Facebook paying $19 billion for WhatsApp. The growth in other sectors helps covers for such blunders.
Every investor would love to have a FANG-like growth stock in their portfolio, especially if bought around that stock's IPO. You can imagine enjoying the 100 bagger returns that would enable you to easily beat the market.
We've discussed what to look for and the risks this kind of investing implies, but every company is unique and has its own risks that can't be assessed by ticking boxes on a check list. Investing a small percentage of your portfolio in companies that might become the next FANG stocks might be a nice exercise and could spice up your portfolio, but be ready to write off the complete investment if something goes wrong.
An example of buying growth stocks at the wrong time is the CIMQ stocks of the dotcom bubble. Cisco, Intel, Microsoft and Qualcomm were the stars of that market, but investors who were late to the game lost much of their investments, which again demonstrates how important timing is when investing in growth stocks.
Figure 5: Intel's stock price. Source: Yahoo Finance.
Growth stocks are a completely different investing world than the standard investing concept of discounting future cash flows, current valuations and debt ratios, and are therefore much riskier. On the other hand, without taking those risks, your portfolio is missing out on the companies that are shaping this century.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.