“I did mention one thing at the meeting, which I don’t think people appreciated at all… So you have close to 10% of the market value perhaps of the United States in five extremely good businesses that essentially take no capital. Now that was not the case in the past.” -Warren Buffett
Starting on September 24th, Apple is the only technology stock in the market leading group of stocks referred to as FAANG. Instead, FAANG will be dominated by Communication Services stocks, a new market sector that Standard & Poor’s and MSCI have developed to better categorize what has emerged as one of the most important segments of the US economy (more details here and here).
Much of the media coverage on the creation of this new sector has focused on the short term impact of index rebalancing and investment flows between sectors. With $260 billion invested in sector ETFs, this focus makes sense. However, the coverage glosses over the far more important issue; what has given rise to the emergence of a new economic sector? Over 10% of the market cap of the S&P 500 will be represented by the Communication Services sector, making it the 4th largest sector of the market. Some of the most important companies in the world will be in this sector, with many of them coming into existence over just the last 15 years. This is an unusual development and one that investors need to understand if they hope to understand the changes that have roiled the global economy and seek to achieve superior investment results in the future.
With the launch of the Communication Services sector, Standard & Poor’s and MSCI are recognizing that unlike technology companies that compete with each other based on product specs and speed, many of the dominant businesses previously categorized as technology stocks simply utilize advanced technology as they offer communication platforms to their users. The fact is, “technology” isn’t even really a type of business sector, the way health care or finance clearly is. Today, almost all businesses deploy significant technology. Car companies, for instance, which clearly sell a piece of technology, are not included in the tech sector because of the maturity of the technology they sell. This is why Apple is a tech company, but a company selling toasters is not. Toasters were once “technology”, but today they are basic consumer products.
One of the striking characteristics of the current long bull market is the way it has been led by a group of very large companies that have continued to grow revenue and earnings at unprecedented rates. While bull markets are often powered by a relatively small number of stocks, the so called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have been unusual in that they are huge companies (all with market caps over $100 billion) growing far faster than large companies typically grow.
Collectively these companies grew revenue in 2017 by almost 20% to well over half a trillion dollars. Excluding Apple, which grew at only 6%, the rest of them grew at an astounding 30%.
Big companies aren’t supposed to grow this fast. According to Michael Mauboussin’s Base Rate Book, only about 6% of companies as large as the FAANG stocks have grown at this rate for even just one year. Yet these companies have been growing this quickly for some time and are widely expected to continue this heady growth in 2018. Mauboussin’s data shows that the percent of companies this large that have historically grown this quickly for a three year period is just 1.7%.
So what’s going on here and what does it mean for the stock market? One common refrain is that we are seeing a new stock market bubble, a replay of the technology boom of the late 1990s. But these companies dwarf the tech companies of the late 1990s. Their average revenue is almost six times larger than the revenue that was produced by Cisco, Intel, Microsoft and Dell (the so call Four Horseman of the tech bubble) in the year 2000 and yet, except for Apple, the FAANG companies are growing even faster!
It is also notable that while many top investors refused to buy technology stocks in the late 90s, many of the great investors today are heavily invested in FAANG stocks. Indeed, Warren Buffett was mocked for having fallen behind the times for refusing to invest in the 90’s Four Horseman, but last year he referred to FAANG as “ideal businesses.” When CNBC’s Becky Quick asked Buffett, “Would you like Berkshire’s businesses to be more reflective of that sort of new paradigm?” Buffett said “I’d love it.”
So we have the official categorizers of companies, industries and sectors recognizing that something different from “technology stocks” has emerged in recent years and we have the greatest investor of all time, one not prone in the least to falling in love with new fads, validating that we are indeed faced with a new paradigm.
So what does all this mean? These are the questions we think investors need to be wrestling with.
- Tech stocks have historically been characterized by rapid competitive cycles, industry leaders that are replaced regularly by upstarts, and limited regulation. But communication businesses around the globe have often operated within stable competitive environments, stable industry leadership, and significant regulation. Is this the future for Alphabet, Facebook, Netflix and other communication services businesses?
- The idea that “tech stocks” have been leading the market is simply wrong. The stocks shifting from the tech sector to communication services have outperformed the remaining tech sector in eight of the last nine years. With the remaining tech sector dominated by older companies like Intel, Cisco, Oracle, Microsoft and IBM, is “tech” still a sector investors will want to overweight? Will “tech” analysts and “tech” focused hedge funds become a relic of a previous era?
- Historically, communication businesses that require little capital, such as media content companies, have enjoyed high earnings multiples even once they are mature, while mature tech stocks often get assigned low multiples. This is related to the duration of competitive advantage periods with technology-based moats often decaying much more quickly than the network effect-based moats found in communication business as old as AT&T and as new as Twitter. Do investors need to re-evaluate the appropriate earnings multiples for both the new communication services stocks and the remaining technology stocks? Given the stable industry characteristics of communication businesses and the still high growth rates of the current leaders in this sector, might these businesses offer the potential holy grail of low volatility and high returns?
These are hard questions. We know that we don’t have all the answers. But we do know that it is often half the battle in investing just to make sure you asking the right questions. “Are we in a second tech stock bubble?” is now objectively the wrong question as the stocks most frequently cited in these discussions aren’t even tech stocks. But that by no means suggests that the FAANG stocks or Communication Services sector stocks are sure things. For all we know, communication services businesses of today will come and go as quickly as many tech companies do. Maybe they do not have the durable competitive characteristics and industry structure that has led so many communication businesses of the past to remain good businesses over long periods of time.
Because humans need to be able to categorize information and fit it into a broader narrative in order to understand it, it is critical that the mental models you use to do this are kept current. The fact is that for all the market commentary about “tech stocks,” other than Apple most of the largest, top performing companies today are not tech stocks. The rules and assumptions that investors apply when investing in tech stocks are not going to work with these companies. Yet what rules and assumptions will work is not yet know. But the spoils will go to those investors who are quickest and most effective in grappling with these questions. Step one is recognizing that new questions need to be asked.
As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Alphabet (GOOGL), Apple (AAPL), Netflix (NFLX), and Oracle (ORCL). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.
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