What a difference a year can make on Wall Street. In 2021, investors endured little pain, with the benchmark S&P 500 contending with no bigger than a 5% correction. In 2022, however, the S&P 500, along with the iconic Dow Jones Industrial Average and growth-focused Nasdaq Composite, all entered bear markets and produced their worst returns in 14 years.
This year, a new headwind has entered the picture. According to the minutes from the March Federal Open Market Committee (FOMC) meeting, the 12-member policymaking body that oversees open market operations is modeling a "mild recession" for later this year.
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Historically, recessions have been bad news for stocks, with the bulk of broad-market downside occurring after, not prior to, the declaration of a recession. But when volatility and uncertainty pick up on Wall Street, new and tenured investors tend to turn their attention to the FAANG stocks.
Investors flock to the FAANG stocks when there's trouble
When I refer to the "FAANG stocks," I'm talking about:
- Facebook, which is now a subsidiary of Meta Platforms
- Apple
- Amazon
- Netflix (NFLX -0.74%)
- Google, which is now a subsidiary of Alphabet (GOOGL -2.98%) (GOOG -2.92%)
The reason investors gravitate to the FAANGs is simple: They're outperformers. Over the trailing 10 years (as of April 18, 2023), Netflix, Apple, Meta, Amazon, and Alphabet (Class A shares, GOOGL) have delivered respective returns of 1,330%, 1,090%, 748%, 689%, and 446%. By comparison, the S&P 500 is higher by 170%.
We're also talking about a group of companies that are leaders within their respective industries and on the cutting edge of innovation.
- Meta Platforms is the company behind four of the most downloaded social media apps in the world (Facebook, WhatsApp, Instagram, and Facebook Messenger).
- Apple has been the world's most valuable brand for 10 years running, per Interbrand, and is the leading provider of smartphones in the U.S.
- Amazon was expected to account for nearly 40% of U.S. online retail spending in 2022, according to eMarketer. That's more than its 14 closest competitors, combined.
- Netflix is the domestic and international market-share leader in streaming services.
- Alphabet's Google has a veritable monopoly in global internet search.
But even industry leaders can offer mixed returns during an economic downturn. If a U.S. recession does materialize later this year, one FAANG stock stands out as a surefire buy, while another would be best avoided.
The FAANG stock to buy hand over fist if the U.S. dips into a recession: Alphabet
If the FOMC is correct and the U.S. economy shifts into reverse in the second half of 2023, the FAANG stock that stands out as an incredible buy is Alphabet. It's the parent company of Google, streaming service YouTube, and autonomous-vehicle company Waymo.
The biggest headwind Alphabet is dealing with is the advertising weakness that pretty much always accompanies economic uncertainty. Alphabet generates a sizable portion of its revenue from ads, so an economic downturn would be expected to weigh on sales and profit growth.
But as I've previously opined, this is a two-way street. Even though economic downturns are inevitable, every recession after World War II has lasted just two to 18 months. Comparatively, economic expansions are almost always measured in years. Since the U.S. economy spends a disproportionate amount of time expanding, ad-driven stocks tend to be smart buys during short-lived recessions.
Alphabet's core operating segment continues to be Google. Since late 2018, Google has controlled no less than 91% of worldwide internet search share, per GlobalStats. With a 90 percentage-point lead over its closest competitor, Google typically commands excellent ad-pricing power.
However, the intrigue surrounding Alphabet has more to do with where the company is investing its abundant cash flow. For instance, Google Cloud has become the world's No. 3 cloud infrastructure provider. Despite a challenging 2022, Google Cloud's losses have narrowed, and the segment is generating in excess of $29 billion in annual run-rate sales.
YouTube is turning heads, as well. More than 50 billion YouTube Shorts are being watched daily -- that's up from around 30 billion during the first quarter of 2022 -- which offers a potentially lucrative monetization opportunity. Further, YouTube is the second-most visited social platform in the world.
The cherry on the sundae for Alphabet is that, fundamentally, it's the cheapest of all the FAANG stocks. Shares can be purchased right now for about 17 times Wall Street's forecast earnings for 2024 and just 11 times estimated cash flow. Over the past five years, Alphabet has averaged a forward earnings multiple of 25.2 and a price-to-cash-flow multiple of 18.4. It's simply never been this cheap as a publicly traded company.
Image source: Getty Images.
The FAANG stock to avoid if a U.S. recession arises: Netflix
On the other side of the aisle is the FAANG stock investors would be wise to avoid if the U.S. is headed into a recession: streaming-service behemoth Netflix.
In some ways, Netflix has impressed since the COVID-19 pandemic began. Most notably, the company has followed years of net cash outflows tied to its international expansion efforts by (finally) generating positive free cash flow. This was especially true during the first quarter, when Netflix produced a whopping $2.12 billion in free cash flow.
Netflix is also still the global leader in paid streaming memberships. As of the end of March, it had 232.5 million paid subscribers, which is a testament to the breadth of Netflix's content library, as well as the intrigue of its original shows.
But it's not all peaches and cream for the world's top streaming service. One of Netflix's biggest headwinds is the revenue it loses from password sharing.
The company previously announced plans to crack down on password sharing by introducing a paid sharing service that allows primary accounts to share their passwords with people outside their households -- for a fee. Unfortunately, the handful of markets where this paid sharing service was tested initially resulted in net cancellations. Although the paid subscriber base in these test markets is now higher than when this paid sharing service began, the lesson seems like Netflix doesn't have the pricing power it believes it does.
To build on this point, Netflix also lost subscribers last year after raising its monthly membership prices in the United States. While password sharing was a reason cited for this brief subscriber decline, it was a clear message from consumers that Netflix's pricing power is waning, despite it being an industry leader.
Competition is another clear concern for Netflix. At the moment, its monthly subscription price point tends to be a bit higher than its competition. While this may not be a problem when the U.S. economy is firing on all cylinders, it could be a serious issue during a recession.
As a reminder, Paramount Global's Pluto TV ended 2022 with 79 million monthly active users and is a free, ad-supported platform. "Free" can be an extremely compelling price point if the U.S. economy shrinks.
Lastly, Netflix is a lot pricier than you might realize. On the surface, trading at 23 times forward-year earnings might not sound too bad. However, the FAANG stocks are known for aggressively reinvesting in their businesses, which is what makes cash flow a better measure of value for the group. Whereas Alphabet is cheaper than ever, based on Wall Street's forward-year cash-flow estimates, Netflix is still pricey at 26 times next-year's estimated cash flow.
With Netflix likely to lose market share as legacy TV networks expand their streaming offerings, smart investors should consider looking elsewhere if a recession arises.
