The Nasdaq Will Lag While FANG Growth Drags

Now that Amazon.com Inc. (NASDAQ:AMZN) and Alphabet Inc. (NASDAQ:GOOG) have reported their 2Q19 results, Big Tech looks closer than ever to hitting a collective wall.

I don’t hate these companies or their smaller counterparts in the “FANG” group: Facebook Inc. (NASDAQ:FB) and Netflix Inc. (NASDAQ:NFLX). They provide essential services to hundreds of millions of people.

And they make a lot of money. However, they’re still priced for the hyper-growth trajectories they were on years ago, before Big Tech swelled to trillion-dollar proportions.

That growth is slowing, sometimes dramatically. With these four companies accounting for 25 percent of the 3,300-stock Nasdaq Composite, they’re no longer the engine driving that technology-heavy index.

Their weight is becoming a drag. As I explained on Bloomberg Radio early this week, I still believe the S&P 500 can climb another 5 percent into record territory this year before the real fun picks up again in early 2020.

The Nasdaq, on the other hand, looks like it’s gone as far as it can. For a lot of fund managers who counted on these stocks to capture an outsized slice of economic growth and capital flow, that’s a problem.

Mega-Cap Trap

Add up the FANG and you’re looking at $2.5 trillion in market capitalization backed up by about $80 billion in profit. That 30X earnings multiple isn’t a red flag in itself, if the companies are still expanding fast enough to grow into that collective valuation.

Until last night, it was a close call. But now it’s clear that AMZN, the biggest of the group, has swung back to its old “revenue at any cost” strategy, spending a staggering $800 million so far to support one-day Prime shipping.

Amazon CEO Jeff Bezos doesn’t see any profit growth there at all for months to come. And NFLX management has committed to spend a fortune on original programming as well, leaving its bottom line vulnerable.

GOOG had a great quarter, but management remains elusive about whether this is only a one-time boost or a taste of better things to come. Until we know for sure, we’re left with the prospect that the biggest profit engine of the FANG has stalled.

That’s not a good thing. My models currently predict no more than 10 percent earnings growth for the entire group. Looking at consensus, I’m having a hard time shaking the suspicion that I’m being too lenient.

That’s not enough to make that 30X group multiple attractive, even if GOOG has shifted into high gear and AMZN doesn’t keep its foot on the brake. Even if the rest of the Nasdaq is crowded with better opportunities, it’s going to have a hard time fighting uphill.

But the S&P 500 remains a better reflection of the economy as a whole, without the reality distortion fields that screen so much of modern Silicon Valley from close analysis. The FANG stocks are only 6% of that index, so the drag will be lower.

In fact, factor out the FANG stocks and the S&P 500 doesn’t look expensive at all, especially in the face of declining interest rates ahead. The ex-FANG market is trading at 14.5X earnings right now. That’s easily enough for the broader index to hit 3,100 by the end of the year, maybe even 3,200.

When I recently told the Bloomberg television anchors that, they gasped. Evidently even a little conviction to the upside is hard to find these days. However, I’m the one who was shocked by their surprise.

The U.S. economy is as robust as anything we’ve seen in the past decade. Profit margins for normal companies are high, thanks to tax relief and soon lower interest rates as well.

Many of those companies missed out on the whole FANG boom. Their stocks are relatively cheap on both a current earnings basis and when you factor in anticipated growth.

Take Houlihan Lokey Inc. (NYSE:HLI), for example. It’s one of the top investment banks in its field, notable for strategic advice and restructuring services. The business may not have all the glitter of Silicon Valley, but I suspect earnings are expanding at least as fast as FB and a lot faster than GOOG.

At 14.6X earnings, it’s a whole lot cheaper than anything the FANG provides. And if the economy softens, HLI will have more clients than it can handle at a moment when most of the FANG stocks scramble for meaningful revenue growth.

Or if you’re obsessed with technology, the market is full of names like Flex Ltd. (NASDAQ:FLEX). Based in Singapore, the company provides manufacturing support for Apple Inc. (NASDAQ:AAPL) and other businesses.

Think of FLEX as a proxy on AAPL and other Big Tech brands. Here too, earnings are expanding about as fast as FB and a lot faster than GOOG, much less AAPL itself… yet that growth is available at barely an 8X multiple.

People were afraid of anything connected to technology in Asia. But here’s the thing: FLEX has factories in Brazil, Tennessee, Texas and beyond. It is a lot more than China, and as the trade war continues, those are the factories AAPL and other customers will use.

It is a win for everyone. These are the kinds of stocks I’m focused on for GameChangers subscribers now. They operate behind the scenes. They’re not trillion-dollar titans yet.

The real upside remains for the subscribers of today to capture for the future.