As 2018 winds to a close, it's provided an excellent reminder to the investing world that nothing goes up in a straight line. This quarter has brought with it the steepest correction in a decade and, at one point, the worst December decline in 80 years.
Then again, it's not as if investors are exactly suffering -- especially those who bought and held the FAANG stocks since their bottom in March 2009. Facebook (FB +1.81%), Apple (AAPL +2.65%), Amazon.com (AMZN +0.26%), Netflix (NFLX 9.71%), and Google, now a subsidiary of Alphabet (GOOG +1.99%)(GOOGL +1.71%), have accounted for a significant portion of the Nasdaq Composite's and S&P 500's returns over the past decade.
As we look toward 2019, a reasonable case could be made for purchasing all five of these beloved tech and consumer giants. Yet, upon deeper digging, it becomes apparent that one deserves to be left on the sidelines.
Image source: Facebook.
Catalysts aplenty for the FAANG stocks
I'll be the first to admit that the FAANG stocks have plenty to offer in terms of high growth and potentially sustainable competitive advantages. Here's a brief synopsis of why each of these five companies could be set into a portfolio and potentially forgotten about for years.
- Facebook: This is the king of all social media sites. Despite its recent data security concerns, Facebook has 2.27 billion monthly active users, and it owns four of the seven most popular social media platforms (Facebook, WhatsApp, Messenger, and Instagram). While there are other social media networks for users to interact, there's no platform where advertisers can reach so many eyeballs at once -- and Facebook knows this. As the company moves to further monetize Messenger and improve average revenue per user in Europe and emerging markets, its profitability could soar.
- Apple: The first trillion-dollar company in history, Apple is at the center of innovation. Its iPhone remains synonymous with success in the U.S., and it could be about to benefit from a tech-upgrade cycle tied to the rollout of 5G networks. And the company has many other moneymaking projects, including the iPad and Mac lines, and its Apple Music service. As the icing on the cake, Apple has a cash hoard of $237.1 billion that could, theoretically, be used to buy any of the largest publicly traded companies, except for the top 15 (three of which are part of the FAANG group).
- Amazon: This e-commerce giant, according to eMarketer research, was responsible for 49.1% of all e-commerce sales as of the midpoint of 2018. For context, its next-closest e-commerce competitor is eBay with 6.6% of all online sales volume. But Amazon is about more than just retail. Cloud-based Amazon Web Services (AWS) is growing at just under 50% year over year, and its operating margin in the latest quarter had expanded to 31%. AWS has really become Amazon's moneymaker, and it shows no signs of slowing.
- Netflix: This is another company seemingly firing on all cylinders. Netflix saw a 36% increase in streaming revenue during the third quarter, with almost 7 million new subscribers, 5.87 million of which came from international markets. Netflix's addition of proprietary series and movies to complement its burgeoning content library has made it a force that other streaming providers are struggling to keep up with.
- Alphabet: And then there's Google, which eMarketer determined had more than 42% of the digital ad market back in 2017. Not to mention, Google's market share for search stands at an insurmountable 92.4% worldwide, according to Statcounter. Add in YouTube, the second most popular social media destination on the planet by monthly active users, and you have a company with growing influence and a rapidly expanding bottom line.
Image source: Amazon.
Forget about this FAANG stock in 2019
As I said, a case can be made that all five of these companies are worth buying. But heading into 2019, Wall Street and investors are considerably more focused on valuations than they've been in a long time. Thankfully, in many instances, these FAANG stocks are looking cheaper than they've been in a while.
However, analyzing FAANG stocks in a traditional way -- i.e., by examining trailing and forward P/E ratios -- typically doesn't work well. Rather, these high-growth stocks are best viewed in the context of their cash flow. The ability to generate positive cash flow from their businesses is especially important, because these are companies that really like to reinvest in future growth opportunities.
Take Facebook as an example. The social media giant is projected by Wall Street to generate $12.47 in cash flow per share (CFPS) by 2020. Over the past five years, Facebook has been valued at an average of 31.4 times its cash flow. Should this 2020 estimate prove accurate, Facebook is now valued at just under 11 times its future cash flow.
The same story is true for Amazon, which has been valued at an average of 30.4 times its cash flow over the past five years. By 2021, as AWS increases in size and the company's margins expand, its cash flow per share could hit $143. That's a future price-to-CFPS ratio of just over 10.
We see similar attractive valuations from Apple and Alphabet. Wall Street's estimated $17.09 in cash flow per share for Apple in 2020 places the tech giant at about nine times future cash flow, which is a bit below its five-year average of 11. As for Alphabet, its five-year average has been 18.1, with the company on track for $71.66 in cash flow per share by 2020. That'd work out to a future price-to-CFPS of less than 15.
Image source: Getty Images.
The outlier is Netflix. Netflix has made no apologies for spending liberally on content, both proprietary and licensed, in order to bolster its domestic subscriber base, as well as lay the foundation for streaming content in international markets. Essentially, it's a spend-at-any-cost strategy to gain as many subscribers as possible.
But there's a downside to this business model. Namely, it burns through capital. Now, this isn't to say Netflix isn't well capitalized, because it is. But Netflix has been burning through its cash on hand for many years now -- and this is a trend that won't change in 2019. In fact, after losing $4 in cash flow per share in 2017, Netflix projects to lose $6.39 per share in 2018 and $5.48 per share in 2019. No one is certain when Netflix will actually begin generating positive cash flow from its business.
In a healthy market where fear is minimal, this is a statistic which could be easily overlooked. After all, Netflix is growing its subscriber base with regularity, and it maintains clear competitive advantages in the streaming space. But in a market where investors are clearly panicking, Netflix's net cash outflow is going to stick out like a sore thumb.
My suggestion: Avoid Netflix in 2019.
