For Wall Street, 2020 has been a year filled with twists and turns. The uncertainty created by the coronavirus disease 2019 (COVID-19) pandemic pushed equities considerably lower during a five-week stretch in the first quarter. This was followed by the stock market staging its most ferocious comeback of all time.
Arguably the only constant in 2020 has been the continued outperformance of the FAANG stocks relative to the broader market.
FAANG stocks have been unstoppable this year
By "FAANG," I'm referring to:
- Facebook (NASDAQ:FB)
- Amazon (NASDAQ:AMZN)
- Apple (NASDAQ:AAPL)
- Netflix (NASDAQ:NFLX)
- Google, a subsidiary of Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL)
On a year-to-date basis through this past weekend, the benchmark S&P 500 was up 6%. Comparatively, Facebook, Amazon, Apple, Netflix, and Alphabet were respectively higher by 38%, 78%, 65%, 59%, and 19%. Having prominent brand names and substantive market share -- e.g., Google regularly accounts for 92% or more of worldwide monthly internet search volume -- has allowed the FAANG stocks to stand out in all the right ways in 2020.
But the big question is: Can FAANG's outperformance continue?
Though a rock-solid bull case can be made for all of the FAANG stocks, one looks to be a substantive bargain. Meanwhile, there's another FAANG stock that investors would be wise to avoid until further notice.
The one FAANG stock you can buy right now
The one thing investors have to understand about evaluating FAANG stocks is that old-school fundamental metrics aren't that meaningful. In other words, price-to-earnings ratios are relatively useless when the companies in question are reinvesting a significant portion of their operating cash flow. Therefore, when analyzing relative value for FAANG stocks, I prefer operating cash flow as the most important metric. Based on operating cash flow growth and forward-year multiples, the one FAANG stock that stands out as historically cheap is Amazon.
Even though e-commerce giant Amazon is valued at 75 times next year's forecasted earnings per share, this figure is practically meaningless given how much of the company's cash flow is reinvested back into growth and customer engagement opportunities.
According to analysts at Bank of America/Merrill Lynch, Amazon currently controls 44% of all online sales in the U.S. Even with razor-thin margins, this is an enviable position for Amazon to be in, especially considering that the U.S. economy relies heavily on consumption. The company has also enrolled more than 150 million Prime members, with the annual fees tied to these memberships enabling Amazon to undercut its brick-and-mortar competition on price.
However, it's the company's infrastructure cloud segment, Amazon Web Services (AWS), that's the real long-term growth driver. With the COVID-19 pandemic forcing many small businesses to beef up their digital presence, AWS stands at the ready to provide the building blocks necessary for businesses to create cloud-based platforms.
In the coronavirus-challenged second quarter, AWS' sales surged 29% from the prior-year period, with AWS accounting for 57% of all operating income. Since cloud margins are much higher than retail or ad-based revenue, AWS is Amazon's ticket to potentially tripling operating cash flow between 2019 and 2023.
Amazon is currently valued at 14.7 times Wall Street's consensus estimate for operating cash flow per share in 2023 ($224.06). Yet, over the trailing five-year period, Amazon has consistently been valued at 30.5 times its operating cash flow. If Amazon is simply treated to the same premium in 2023 as it's been given over the past five years, its stock could double.
The one FAANG stock you should avoid
On the other hand, investors should seriously consider curbing their enthusiasm for technology kingpin Apple, which looks to be easily avoidable at its current valuation.
To clear the air, Apple is a solid company, and no valuation discussion is going to take away from that. It has a well-recognized global brand, a highly loyal group of consumers, and the most valued smartphone on the planet in the iPhone. Apple also pays out more than $14 billion in dividends each year and has been aggressively repurchasing its own stock.
But it's also not a company you should consider buying right now.
Following the euphoria associated with Apple's 4-for-1 stock split enacted on Aug. 31, the company is now valued at 27 times its operating cash flow per share. For those of you keeping score at home, that's more than double its five-year multiple of 13.1 times its operating cash flow. The issue is that Apple's operating cash flow is only expected to grow modestly from $80 billion over the trailing 12-months to $88.2 billion for full-year 2023.
The complete head-scratcher here is that Apple is being valued more like a high-growth services company that can offer consistent double-digit sales and cash flow growth, which it can't. The company's faster-growing services segment has accounted for only 19% of total sales through the first nine months of fiscal 2020, yet Apple's market cap has more than doubled since the March lows. Even accounting for strong iPhone demand when Apple rolls out its first-ever 5G-capable device, it's hard to make a convincing bull case with shares priced at 27 times operating cash flow.
Furthermore, the last time Apple was valued so richly relative to its operating cash flow (December 2007), it subsequently lost more than half of its value. While I don't believe a repeat of that is in order, investors could be sitting on dead money for a long time if they choose to buy Apple at such an aggressive premium.