A Toothless FAANG


After much discussion with Taotao He (Director of Alternative Assets) and Jorge Go (Advisor) at Marto Capital about the current state of the technology sector, we believe the sector is currently undergoing a paradigm shift.

With the overarching theme: Good is the Enemy of Great

Technology has formed the bedrock of the 21st century. It has reshaped our daily lives and captured our imaginations. Not surprisingly, tech has become the growth engine of equity markets. In the 1990’s, IT stocks reflected less than 10% of the S&P 500’s market capitalization. By the end of 2018, its contribution had more than doubled to above 25% of the index (note that this now excludes Apple and Facebook, which have been “reclassified” to communications) – an index that was designed to have a diverse constituency representative of the whole U.S. economy and its bellwether participants.

The top technology stocks have generated most of the equity wealth in the last 10 years, but technology has become largely concentrated. At the end of 2018, five stocks – the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) – comprised ~28% of the S&P 500, and Apple alone was larger than the bottom ~100 companies of the index. In fact, when we look the tech sector, the FAANG stocks comprise the bulk of that too, representing more than 50% of the S&P 500 tech sector. In recent history, they have continued to outperform the S&P 500. The FAANG stocks represent more than 50% of the S&P tech sector.’

There are a plethora of factors for why we believe technology stocks will face downwards pressure such as overvaluation, sensitivity to rate hikes, regulatory headwinds, and a QE induced euphoria. However, if we take off our emerald-tinted glasses and analyze the nature of the technology sector we find ourselves in a perplexing paradigm. The disruptive nature of this industry is one of its greatest assets, but also one of the greatest threats. Tech firms that have seen significant historical growth eventually grow too large and fail to innovate (i.e. the Innovator’s Dilemma). Flexibility, adaptability, and a culture of innovation softens as the firm becomes increasingly bureaucratic, focused on pleasing Wall Street, and is ultimately satisfied cruising at a good speed.

Good is the Enemy of Great.

The core nature of technology is innovation and change. It comes with no surprise that the technology landscape has vastly shifted over the past 10 years. Only 4 of the top 10 Tech companies in 2008 by market cap (Apple, Microsoft, Cisco Systems, and Intel) are in the current top 10 technology firms in 2018. We expect the cycle of disruption to speed up further, making the FAANG stocks unreliable from a long-term perspective.

2008 2018
1 Hewlett-Packard ($104.3 billion) Apple ($1.10 Trillion)
2 IBM ($99.8 billion) Amazon.com ($962 Billion)
3 Dell ($61.1 billion) Microsoft ($883 Billion)
4 Microsoft ($51.1 billion) Alphabet ($839 Billion)
5 Intel ($38.6 billion) Facebook ($460 Billion)
6 Motorola ($36.6 billion) Alibaba ($412 Billion)
7 Cisco Systems ($31.9 billion) Tencent Holdings ($383 Billion)
8 Apple ($24.0 billion) Samsung Electronics ($297 Billion)
9 Electronic Data Systems ($22.1 billion) Cisco Systems ($224 Billion)
10 Oracle ($17.9 billion) Intel ($222 Billion)

Source: Marto Capital Research

Complacency in the FAANG stocks can be seen across multiple avenues. The largest telecommunications companies have not introduced as many paradigm-shifting products as they did in the past – think Google with Google Docs or Google Maps; Apple with the iPod and the iPhone (which now comprises ~60% of revenue).

While it’s easy to view global economic growth in a positive light, as global macro investors, we must always take a step back and evaluate markets and economies through a quantitative lens. We can utilize Marto Capital’s macroeconomic models and proprietary signals to do so.

Our models allow us to discern which signals and drivers have the largest effect on the broader equities space as well as more specifically on the technology sector.

Our research indicates that equities have a negative correlation to a steepening curve across all economic cycles. The graph below shows the relative correlation of different asset classes when the curve steepens across different economic cycles.

Asset Class BehaviorMarto Capital Research

We are also able to dive a level deeper and analyze the correlations of sectors within the equities space. We are able to discern that the technology sector is typically vulnerable when the curve steepens.

Equity Sectors BehaviorsMarto Capital Research

Technology Earning Yield

Technology earning yield over timeMarto Capital Research

While the recent sell-off has improved the technology earning yield, it’s still off levels we sat between 2010 and 2016.

Credit Default Swaps

Technology Credit Default Swaps over timeMarto Capital Research

While CDS spreads are not as high as the levels we saw during the great recession, there has recently been a pronounced uptick in the spread and we’ve blew past local highs. We believe CDS is an important proxy to the health of equity markets and in the graph below reflects the CDS spread of the Technology sector.

Debt to Equity

Debt to Equity over timeMarto Capital Research

Since 2013 we have seen the average tech sector debt-to-equity ratio grow from 40% to 80% - representing a 100% gain in the past 6 years. Current levels are even higher than what we have seen before 2008. Typically, if the debt-to-equity ratio increases, so does risk – as there will be higher interest payments and failure to service higher debt costs may lead to defaults/bankruptcy.

Conclusion          

We believe that the tech boom of the last decade was premised on a unique set of circumstances – primarily characterized by loose monetary policy and excess liquidity fueling a “risk-on” sentiment. As the macro environment shifts from tailwind to headwind, and as the large innovators of the past grow increasingly complacent and subject to regulatory pressure, the big tech edge will slowly be deconstructed. As the tide goes out, we believe that we’ll see the FAANG stocks and their close brethren perhaps not swimming entirely naked, but a little more scantily clad than expected.