„History tells us that of the top 10 stocks in the world, eight will disappear over the next decade.“ Rob Arnott
The FAANG stocks (Facebook, Amazon, Apple, Netflix, Google) have been outperforming the broad market for years. Today they are among the largest companies in the world. I would like to try to illustrate the risk with the FAANG stocks (and many others) using Amazon as an example.
There are some laws that no company can escape. One is that growth weakens at some point as the size of the company increases. Normally, the price-to-earnings ratio (P/E) falls along with weakening growth too.
For 2018, analysts currently expect Amazon’s revenue to be around USD 235 billion with a net profit of around USD 8 billion. This corresponds to a net profit margin of about 3.5%. Currently Amazon has a market value of almost USD 1 trillion with a P/E of 160 (trailing twelve months).
Let’s assume that Amazon’s share price will double in the next 10 years. This is an average annual price gain of just over 7% p.a. Amazon would thus have a market value of roughly USD 2 trillion in 10 years.
Let us also assume that the P/E falls to 25 (which, by the way, would still be pretty high). At a market value of USD 2 trillion, that would be a net profit of about USD 80 billion.
Even if the net profit margin were to double to 7%, sales in 10 years would have to increase almost fivefold to over USD 1.1 trillion to generate a net profit of USD 80 billion which is ten times the current value.
What if, 10 years from now, the P/E is at 20 and the profit margin stays at the current 3.5%? At a USD 2 trillion valuation, revenues would have to increase from currently USD 235 billion to USD 3 trillion. Profits would have to increase twelvefold to USD 100 billion.
Is that possible? Yes, but the chances are small. The real problem, however, is that one would be compensated with only about an average market return for a valuation that has priced in perfection. Is this a good risk/return profile? Probably not.
In addition, many companies have benefited in recent years from several factors that have been favourable for them. These include low oil prices, low wages, low interest rates and lax (data) regulation in the technology sector. And by the way, many US multinationals pay very low taxes. Amazon, for example, didn’t pay any taxes in the US in 20173.
At 11.8%1, large US corporations currently have the highest profit margins ever2. Nobody knows whether this will still be the case in 10 years’ time. The odds are against it because profit margins are mean reverting.
Anything is possible in the short term. However, long-term investors should carefully consider whether it is worth taking such risks.
1 Cohen, S.: “Amazon paid no US income taxes for 2017”, SFGATE, 27 February 2018, accessed 07 September 2018, https://www.sfgate.com, Link to the article
2 Mason, J.: “Profit Margins: Where Are They Going?”, SeekingAlpha, 13 August 2018, accessed 07 September 2018, https://seekingalpha.com, Link to the article
3 Fox, J.: “Small Companies Aren’t Sharing in the Corporate Boom”, Bloomberg, 29 May 2018, accessed 07 September 2018, https://www.bloomberg.com, Link to the article