The inspiration of today's discussion is an article I read the other day comparing the "FAANG Plus M" stocks - Facebook ( FB ), Apple ( AAPL ), Amazon ( AMZN ), Netflix ( NFLX ), Alphabet's Google ( GOOGL ) and Microsoft (MSFT) - to the "Nifty Fifty" of the early 1970s.
The author of the article concludes:
"... in many ways, the FAANG phenomenon is even more dangerous than the Nifty Fifty. The Nifty Fifty were at least somewhat diversified by industry and by name (and as Philip Morris shows (PM), just one lucky position kept the whole portfolio alive). The 'FAANG plus M' stocks, on the other hand, are woefully concentrated by both size and industry and therefore could be vulnerable to a massive sell-off the moment they hit their natural limits of growth. It may have a wonderful, viable business for many years to come, but the natural competition of the marketplace makes it extraordinarily difficult for any company to remain dominant for perpetuity. That's why valuation matters. Ultimately, the thrill of the gain gives rise to the agony of the loss and those investors who are unabashedly bullish on the current crop of superstar stocks would be wise to learn their stock market history."
The conclusion makes sense to me, but I wanted to go a step further and actually compare the valuations of the FAANG Plus M stocks to the Nifty Fifty stocks at their peak.
Let's briefly review the Nifty Fifty. The Nifty Fifty were a group of large-cap, fast-growth stocks, such as Xerox (XRX), IBM (IBM), Johnson & Johnson (JNJ), Eli Lilly (LLY) and Coca-Cola (KO), that became every investor's favorites in the early 1970s. All of these stocks had high growth rates, high growth potentials and high market capitalizations. They were often called one-decision stocks: buy and never sell. Because their prospects were so bright, many analysts claimed the only direction they could go was up. On average, the Nifty Fifty stocks traded at a price-earnings (P/E) ratio of 42 times in the early 1970s.
This group of high-flying growth stocks soared in the early 1970s, but subsequently collapsed during the bear market. Investors in the Nifty Fifty stocks lost 80% to 90% of their money. Forbes magazine retrospectively commented on the phenomenon as follows:
"What held the Nifty Fifty up? The same thing that held up tulip-bulb prices in long-ago Holland--popular delusions and the madness of crowds. The delusion was that these companies were so good it didn't matter what you paid for them; their inexorable growth would bail you out. Obviously the problem was not with the companies but with the temporary insanity of institutional money managers--proving again that stupidity well-packaged can sound like wisdom. It was so easy to forget that probably no sizable company could possibly be worth over 50 times normal earnings."
Let's first take a look at the FAANG Plus M stocks' valuations. The true earnings power of these stocks are by no means easy to estimate. I used Bloomberg's estimates of 2017 normalized earnings as the basis of the P/E ratio. According to Bloomberg, at today's price, both Alphabet and Facebook trade at a little over 25 times 2017's earnings; Microsoft at 27 times 2017 earnings and Apple at 17 times 2017 earnings. Amazon trades at almost 100 times Bloomberg's estimated 2017 normalized earnings and Netflix is trading at over 110 times Bloomberg's estimated 2017 normalized earnings. The average P/E of the FAANG Plus M stocks is 50, while the median is 26.
Amazon and Netflix's valuation levels would have made them the most expensive stocks within the Nifty Fifty universe had they existed back then. In the early 1970s, the most expensive Nifty Fifty stocks "only traded" at between 70 to 95 times earnings. Apple, Facebook, Alphabet and Microsoft are currently trading at the lower end of the Nifty Fifty valuation levels in the early 1970s. As a comparison, in 1972, Pfizer (PFE), Bristol Myers, Gillette, and General Electric (GE) traded between 24 and 28 times earnings.
While the FAANG Plus M stocks appear expensive, compared to what I call the SMID (small and mid-cap), high-quality, fast-growth champions, their valuations do not look that bad. Most of these SMID companies are leaders in niche markets; they had strong growth in the past and are expected to grow fast in the future. Let's look at a few examples.
Align Technology (ALGN) is a leader in the clear aligner dental market. The company grew its revenue impressively for the past several years, but particularly so over the past six quarters, in which it grew 28.6%, 34%, 27.3%,30%, 32.3% and 38.3% respectively. Adjusted EPS is estimated to be about $3.7 this year and grow to more than $7 per share in 2021. At today's price, Align is trading at 70 times 2017 earnings and 36 times 2021 estimated earnings.
Abiomed (ABMD) is another darling in the small- and mid-cap medical device space. The company developed an amazing device called Impella, which is designed to enable the heart to rest, heal and recover by improving blood flow to the coronary arteries and end-organs and/or temporarily performing the pumping function of the heart. Like Align, Abiomed had strong growth over the past several years with the past two years particularly impressive (43% in fiscal 2016 and 35% in fiscal 2017). But at today's price, the stock is trading at a whopping 88 times 2018 estimated earnings and almost 40 times 2021 estimated earnings.
How about a less fancy SMID champion? One of my favorite small-cap companies is called Neogen (NEOG). The company develops, manufactures and markets a range of products and services dedicated to food and animal safety. It is an absolutely wonderful business. Neogen's growth is not as fancy as Align and Abiomed, but it is still a pretty solid double-digit grower, both on the top line and the bottom line. The shares trade at 62 times 2018 earnings and more than 40 times 2021 earnings.
Healthcare Service Group (HCSG), another niche market leader and consistent small-cap grower, has a unique business model that has allowed the company to be a solid and consistent double-digit grower over the past several decades. I imagine the company will continue to grow by double digits into the next decade. The price tag: 40 times 2017 earnings and almost 25 times 2021 earnings.
The list of small- and mid-cap champs trading at bubble-like valuations is not short. In my opinion, investors' obsession with what I call "mini Nifty Fifty stocks" are more pernicious than that of the already hyped FAANG Plus M stocks.
I like most of the aforementioned companies - I think they are wonderful businesses and would love to be a long-term partial owner of them one day. I do not own any of them now and will be sitting on the sidelines if valuations continue to be this elevated. When investors have unrealistic expectations for high-quality growth stocks, they inevitably pay a high price. When the expectations prove to be too optimistic, investors who pay too much for the growth will inevitably learn a hard lesson. I see a considerate amount of greed, irrational exuberance and excessive risk-taking in today's markets for high-growth, high-quality champions. In times like this, we should all remember Mark Twain's wisdom: "History doesn't repeat itself, but it often rhymes."Premium Members
This article first appeared on GuruFocus .