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Time To Short FAAMG?

FAAMG Relative to the Sector and Market

Time To Short FAAMG? To mitigate the risks of exceedingly optimistic markets, overvaluation investors should be aware of the fundamental metrics. These metrics are used to understand whether a market is relatively expensive or not. These financial metrics must compare the intrinsic value of a company to its market capitalization.

Benjamin Graham, who was, and still is considered the spokesperson for value investing, points out that market sentiment plays a large part in the forming of bubbles.

And an indicator of a potential bubble is a spike in the number of initial public offerings that occur.

This is because companies take advantage of clearly optimistic markets to extract the most money possible for their insiders and investors. Considering this theory, the inflated number of IPOs in the information technology sector from 2020 to 2021 may be concerning to investors in the sector. 

Since October 2019, there has been a clear outpacing by the information technology sector in comparison to all other sectors. The SRIT, an S&P 500 information technology-centric index, has nearly doubled in value from $1,400 to $2,798. This growth represents a 41.4% CAGR. For reference, the health care index has grown by 50%, while real estate and financials have grown 24.8%, and 33.5%, respectively. The energy sector has seen a diminution of 21%. Although empirical evidence has suggested this to be common, the residual growth between IT and other sectors is expanding. 

In this time period, the influx of retail investors coupled with governmental financial stimulus through both fiscal, and monetary policy, has led to higher-than-normal growth by the largest cap technology companies in America.

Companies such as Facebook, Apple, Amazon, Microsoft, and Google (FAAMG), have experienced inflated financial metrics and unrelenting growth. These companies make up great proportions of the portfolios of numerous demographics, making a potential bubble, and subsequent burst, detrimental. 

If creating a portfolio of the listed companies, weighted by market cap, the allotted funding by percentage would be, .20 towards Google (GOOGL), .185 towards Amazon (AMZN), .2688 towards Apple (AAPL), .11 towards Facebook (FB), and .236 towards Microsoft (MSFT).

A total market cap of $9,632 billion.

This value would make the companies the third-largest country in the world if compared to the GDPs of nations.

In order to understand if these companies are intrinsically worth this much, there must be some comparison to sector averages in terms of accounting ratios. The formerly constructed portfolio distribution will act as the weight of the financial metrics of these companies so they can be judged as a unit.

When considering the current P/E ratio of the portfolio, using earnings from the trailing twelve months, the portfolio exhibits above-average prices relative to earnings, with a trailing portfolio P/E ratio of 37.45. To put into historical perspective the magnitude of this P/E ratio, in May 2018 the S&P500 had an average P/E ratio of 24.3, which fell 22% during the remainder of the year. During this same period, the average FAAMG P/E fell from 32 to 23, representative of an almost 29% decline.

During this time period, the average P/E for FAAMG companies was 33% greater than the S&P average. And demonstrated a 33% greater decline during the downswing.

Currently, the average FAAMG P/E for the created portfolio exceeds the S&P average by ~10%. This is partially counteracted by the lower average beta. Or a higher correlation to the market, that the portfolio demonstrates relative to 2018. 

If the trajectory of earnings growth continues, forward P/E ratios in the coming FY will decline. All FAAMG constituents are projected to demonstrate a weighted average earnings growth of 13.8%. This would be reflective of a P/E ratio of 32.15 if holding constant price per share.

When considering highly variable 2023 projected earnings, the weighted FAAMG P/E ratio would amount to 27.9. This P/E ratio is consistent with the 2018-2019 average P/E ratio for the same basket of companies. And seems to be the point at which the metric reverts to following extreme swings in either direction. 

Another potentially suitable metric to determine the added market value of FAAMG companies may be EV/EBITDA. The current IT sector average EBITDA multiple stands at 22.87. The weighted EV/EBITDA multiple of the constructed portfolio would amount to 23.6. Although a seemingly small difference, this falls in the 80% percentile of the EV/EBITDA occurrences in the sector. 

In conclusion, the culmination of these market value indicators shows that the predictors of financial stimulus, increased interest from retail investors, and over-optimism about the future may be expanding the bubble that is the five largest holdings of the S&P 500.

However, as mentioned previously, the lower-than-usual beta metric for the companies would be representative of a subdued decline in the case of a market crash.

Time To Short FAAMG? Written by Hakil Haxhiu

Edited by Jimei She

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