A valuation anomaly occurs when share prices diverge from the underlying prospects for a business. Today such an anomaly encompasses an entire universe of so-called quality stocks (including the ‘bond proxies’), in addition to the FAANG stocks of the US market.
The prevailing wisdom has been to own these stocks forever, irrespective of valuation. 
A combination of an amelioration of macro-concerns and disappointing Q3 results last year led to the underperformance of many of these quality stocks as investors reassessed their fundamental prospects. Despite the pull-back, quality stocks remain expensive as they are in the 96th percentile of valuation (source: Morgan Stanley).
The valuation of the FAANGs has also boosted the performance of the US market and has led to the US market significantly outperforming the European stock market over the last 10 years. The outperformance has reached well over a two standard deviation event, which is incredibly rare (<5 per cent probability). Clearly a massive driver of the US’s outperformance has been the growth of technology stocks, which has not been replicated within Europe.
US equities at 70-year high versus Europe
Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data
The scale of relative outperformance has reached levels that appear to us as being within ‘bubble territory’.
In the chart below we consider the original FANG stocks (including Apple) and show the performance against the S&P 500 over the 5 years. This shows the bubble is being inflated by the largest stocks in the biggest and most liquid stock market in the world.
FAANG stocks are driving the US market higher
Source: Bloomberg
Anomalies persist frequently for small and mid-cap companies, which either have poor analyst coverage or where they can achieve explosive growth from a low starting point. However, it is rare big businesses can achieve this, partly due to their already high market shares, but also because companies are rarely able to achieve supernormal returns indefinitely: they tend to attract competition or regulators.
To put this into context Apple, Microsoft and Google now have market capitalisations over $1trn and Amazon is within 7 per cent of joining the club. To justify these valuations, we must conclude investors believe that their growth prospects are still bright and remain underappreciated by investors.
We are frequently told that it is indeed “different this time” and not a repeat of 2000. The FAANG stocks are embedded into our daily lives and have massive and sustained growth ahead of them. We are told that these shares will grow into their current ratings and will remain the “must own stocks” given the current anaemic global growth rate.
We have no doubt that the FAANGs are currently great companies. The debate for investors is about investment processes and at what valuation point to consider selling these shares. We see the long-term risks posed by global antitrust authorities and tax authorities given the current lack of regulation and tax paid.
Our view is that there is a significant optimism in the share valuations and investors who perhaps have one eye on the benchmark are dispensing with their sell process in order to continue owning these highly rated shares. This can persist for some time, but we don’t believe it’s different this time. If the best way to generate returns is to calculate the value of a business and buy it at a significant discount, then owning overvalued and over-owned shares is playing with fire.
While many of these businesses have currently strong market positions, it would be naive to suggest that technological change will not bring new competitors or that returns may not fade as the business matures, or regulators become more interested in competitive practices. We have no idea about the catalyst for a change in market leadership – as ever these will only be obvious in hindsight. However, we would make the following observations.
The chart below looks at the market concentration in the US market over the last 25 years. It highlights a couple of very interesting points. Firstly, the top-five companies now represent 18 per cent of the total market capitalisation of the S&P. This is unparalleled, even in the 2000 tech bubble where the top-five represented 16 per cent. Secondly, like 2000, there is a growing divergence between the top-five companies and their share of net income – i.e. the market capitalisation is a result of a re-rating of the shares as opposed to growth in net income. We do not believe this is sustainable.
Growing divergence between the largest companies in the S&P and their net income contribution
Source: Bloomberg, FactSet, Morgan Stanley Research
We observe the lofty PER’s particularly on Amazon, Apple and Microsoft – which has re-rated from 9x to 30x in the last eight years. We also note the lack of dividend yields on offer.
The relative performance of the technology sector has significantly outpaced earnings in recent years. For example, at the beginning of 2015, the consensus five-year earnings growth for Google – now called Alphabet – was 18 per cent. Today that figure has dropped to 15 per cent, yet the shares have re-rated by over 40 per cent over the intervening five-year period.
Apple shares were up an astounding 85 per cent in 2019 having re-rated by over 50 per cent over the last five years. The market capitalisation of Apple is now close to topping the entire Australian market. We need to remind ourselves that Apple is a primarily a hardware company that earns most of its profits from selling high quality but expensive mobile phones and is clearly prone to product cycles.
Whilst these trends can persist, share prices must follow earnings over the long-term. Earnings will have to increase materially, or the share prices will fall. We suspect it will be the latter.
It is impossible to disaggregate the key drivers of the current outperformance of the FAANG stocks. It may be a combination of low interest rates, low economic growth, the relentless shift to passive investing, as well as the development of the ETF market and benchmark driven investors being forced to own some of the shares given their weight in the index. Or perhaps we need look no further than the liquidity provided by the Federal Reserve balance sheet which is flowing to the largest and most liquid names at the top of the S&P 500.
The dynamics of outsized US market performance and the extreme valuation of some of the largest companies in the index ties in with our research and portfolio positioning, which suggest that there are better opportunities for investors in other sectors and global markets.
So, what do we expect to happen from here?
Our central case is that global economic growth persists. If this occurs, we would expect the market leadership to change and market concentration to expand to more attractively valued parts of the market given the significant valuation differential. The less palatable outcome is a significant market correction caused by a growth scare or inflation shock, which will affect all parts of the market but particularly the expensive growth stocks. We would then get a proper understanding of how much of the current bubble is being driven by excess liquidity and ETFs.
We have seen this movie before, and it didn’t end well. Owning expensive shares in the hope that you can sell them to someone else at a higher price, is not a game that we would encourage any investor to play. Especially not in companies which are massively changing our daily lives but are not regulated and arguably don’t pay their fair share of tax.
David Keir is chief executive of Saracen Fund Managers. The views expressed above are his own and should not be taken as investment advice.