Investors looking for big gains in the stock market know some of the biggest success stories of the past decade. Fast-growing stocks of some of this century’s most iconic companies have captured a lot of investor attention — so much so that they’ve been given their own classification: so-called FAANG stocks.
What exactly are FAANG stocks and why should investors pay attention to them? And are they worth investing in today?
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What Are FAANG Stocks?
The term FAANG was coined by television personality and investor Jim Cramer as an acronym representing some of the largest technology stocks listed on the stock market today. The acronym breaks down as follows:
- Facebook (NASDAQ: FB) is a massive social network boasting nearly 3 billion active users. Subscribers connect with friends and family, look for jobs, buy and sell products, and more on the massive platform. This activity has driven the company to trade with a market cap of more than $1 trillion and helped it to solidify its place as one of the top 10 largest companies in the world.
- Apple (NASDAQ: AAPL) is the technology giant behind the iPhone, iPad, and a long line of other products. The company’s state-of-the-art technology and ability to create a complete ecosystem around its products has made it a goliath. In fact, with a market cap of more than $2.4 billion, it’s the largest company in the world.
- Amazon (NASDAQ: AMZN) got its start as an e-commerce platform, accepting low margins to appeal to the masses. Well, that bet paid off. Today, it’s one of the largest retailers in the world. It’s also a major player in the world of cloud computing, artificial intelligence, and nearly all things tech. The company has a market cap of more than $1.6 trillion, making it one of the top five largest companies in the world.
- Netflix (NASDAQ: NFLX) is somewhat smaller than the companies listed above, but placed in the top 40 largest companies in the world, it’s nothing to shake a stick at. The streaming service offering original content and syndicated content from other sources has grown to trade with a more than $242 billion market cap.
- Google. Finally, Alphabet (NASDAQ: GOOG | GOOGL) is the parent company to Google, the world’s most popular search engine. While the company is best known for its search and advertising business, it has become a major player in tech, with its hands in everything from self-driving cars to cloud computing. Today, Alphabet is the fourth largest company in the world with a market cap of more than $1.8 trillion.
In some cases, investors associate Microsoft (NASDAQ: MSFT) with this group of stocks, and for good reason. Microsoft is one of the largest tech companies (and companies in general) in the world, trading with a market cap of more than $2.2 trillion and second in size only to Apple. When Microsoft is included, some people change the acronym to “FANMAG.”
There are a few similarities you’ll notice among these companies. They are all major players in tech, are all incredibly high-value companies, and all are household names.
Moreover, every stock on the list qualifies as a growth stock because they’re known for generating significant revenue, earnings, and share price growth on a consistent basis.
Interestingly, while this class of stock represents only 0.01% of the number of stocks listed on the S&P 500, they represent about 15% of the total value of the index. As a result, any changes to the stock prices of this handful of stocks can result in significant movements in the major market indexes.
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Why Are Investors So Excited About FAANG Stocks?
There are plenty of reasons why these stocks are so popular. Some of the most significant being:
Every name in this class of stock represents a popular company that’s a staple in the United States. Think about it — is there a single name listed above that you haven’t heard of?
At the end of the day, investors like investing in what they know. Stocks of household names will always have demand on Wall Street.
Retail investors often follow the moves made by big-money investors, and for good reason. The big money knows where the deals lie. Each of these stocks is a common staple found in a wide variety of exchange-traded funds (ETFs), mutual funds, and index funds, making them prime picks among the institutional crowd.
Compelling Historic Growth
If you look at the historic performance of any stock in this group, chances are you’ll be impressed. Not only have these companies experienced consistent growth in revenue and earnings, their stock price appreciation has been mind-blowing.
Company 5-Year Change in Stock Price
Google (Alphabet) +253.91%
For most people, there’s an allure surrounding new technology that you just don’t find anywhere else. Potentially life-changing new products and services are interesting topics of discussion, often leading to deeper research among investors than they would be inclined to do on, say, a traditional energy company or consumer staples stock.
After all, the most profitable decisions in the stock market also tend to be the most educated decisions. Investors tend to be more effective when they’re researching the types of companies and products they’re personally interested in.
Because research is more enjoyable, a larger group of investors is interested in technology plays than other sectors. And because the FAANG category represents the biggest players in tech, it only makes sense that it’s overwhelmingly popular.
Is There a FAANG Stock Bubble?
Whether high-flying FAANG stocks are in a bubble is the question of the century, and if anyone tells you they have their answer, chances are they’re wrong. Nonetheless, it is a major debate worth considering.
Following the enormous growth in the FAANG category outlined above, stocks in this category have climbed to significant valuations. Many argue that the tech sector as a whole — especially the FAANG stocks — are in bubble territory.
Bubbles happen when investors accept increased risk to invest in a specific category of stock, knowing that the stocks within the category are overvalued. Oftentimes, investors pile money into stocks in bubbling sectors with little research, driven by the fear of missing out, or FOMO.
One of the metrics most commonly used to gauge the valuation of stocks is the price-to-earnings (P/E) ratio. The P/E ratio compares the price of a single share of a company to the earnings per share the company generates over the course of a year. Comparing a company’s P/E ratio with other companies in the industry gives you a sense of whether the stock is overvalued or undervalued relative to its peers.
On average, tech companies trade with a P/E ratio of around 34 (current average as of August 2021). Here’s how stocks in the FAANG category stack up:
- Facebook. Facebook currently trades with a P/E ratio of around 26, which is substantially lower than the broader technology sector.
- Apple. Apple trades with a P/E ratio of around 28, which is also substantially lower than the technology sector average.
- Amazon. Amazon.com currently trades with a P/E ratio of around 56, which is substantially higher than the average in the technology sector.
- Netflix. Netflix also trades with a P/E ratio of around 56, suggesting that the stock is significantly overvalued when compared to the rest of the technology sector.
- Alphabet (Google). Alphabet trades with a P/E ratio of about 29, which is lower than the tech sector average.
Comparing these stocks to the tech sector as a whole, three could be considered undervalued and two overvalued, which doesn’t quite look like a bubble.
However, the entire technology sector’s valuations have been on the rise for quite some time, which is what you tend to see in a bubbling sector. When the sector is growing at a normal pace, you can expect to see P/E ratios closer to the 20 range. Based on this, just about every stock in the FAANG category is overvalued, but so too are just about all tech companies.
While there’s an argument to be made that the technology sector is overvalued, there’s also an argument that the higher valuations are largely justified. Over the past several years, there have been good reasons for gains in the value of stocks that focus on technology. Increasing uses of technology have led to strong consumer uptake, growth in sales, and growth in revenue.
These factors often equate to stock price appreciation.
Although the sector may look like it’s bubbling at first glance, and even may be in the midst of a bubble, the alarm bells aren’t quite ringing yet. Profits across the sector continue to grow at a compelling pace that helps to justify the higher valuations.
Pros and Cons of Investing in FAANG Stocks
As with any other category of stocks, before you decide to invest in FAANG, it’s important to consider the pros and cons.
FAANG Stock Pros
FAANG stocks are overwhelmingly popular, and there are several major benefits to investing in this category. Most importantly:
1. Investing in What You Know
There are clear benefits to investing in companies you’re already familiar with, especially for beginners. Because FAANG stocks all represent household names, when you invest in them, there’s a strong chance you already know exactly what they do and understand the value proposition they offer.
2. Compelling Growth
Every stock in this category has a proven history of compelling growth in revenue, profitability, and share prices. While some suggest the shares are overvalued, the vast majority of experts expect these big tech companies to continue growing.
3. Institutional Backing
While it’s never a good idea to blindly follow any other investor or expert, it is nice to know that institutional investors are interested in the stocks you’re buying. Due to their strong growth characteristics and significant share of most widely accepted market indexes, FAANG stocks enjoy substantial interest from the institutional investing community.
4. Enjoyable Research
Most people enjoy learning about the technology that makes self-driving cars, next-generation smartphones, and touchless thermometers possible. Since research is the foundation of any strong investment decision, the fact that these companies are interesting to research is a major plus.
FAANG Stock Cons
Sure, there are plenty of reasons to be excited about investing in FAANG, but it’s also important to keep in mind that every rose has its thorns. When it comes to this class of stock, the most significant drawbacks to consider include:
1. High Valuations
As a whole, tech stocks are experiencing incredibly high valuations. If valuations continue to grow, they may become too expensive to continue to be appealing to the investing community, which could lead to a sell-off.
The tech category is also volatile. When market and economic conditions are positive, consumers are willing to spend more money on the latest and greatest technology, leading these stocks on a tear upward. However, any negative shift in economic data could be a signal that tech spending will decline, which will lead to declines in the values of these stocks.
3. Saturated Markets
Some investors don’t like investing in the largest companies in the world due to their market saturation. These companies have already tapped into the vast majority of their target market, which has the potential to limit their growth if they stop innovating and giving their audience something new worth buying on a regular basis.
Should You Invest in FAANG Stocks?
For most people, FAANG stocks are a welcomed addition to a well diversified investment portfolio. Representing some of the largest companies in the world, these stocks are more stable than smaller tech companies. And with a strong history of growth, there’s a high probability that an investment will yield a compelling return.
However, stocks in the FAANG category aren’t a wise choice for all investors.
The tech sector generally is riddled with volatility, meaning that when things are good, they’re great — and when things are bad, they’re horrible. As a result, these stocks make sense for an investor with a long time horizon, but aren’t a good fit for older investors who are at or nearing retirement, or for other investors with similarly short-term investing goals.
If the bottom fell out of these highly volatile stocks, investors with short time horizons or who rely on selling stocks to fund their living expenses simply wouldn’t have the time necessary to recover from the drawdowns, which could be detrimental to a retirement portfolio nearing maturity.
How Much of Your Portfolio Should You Allocate to FAANG Stocks?
Asset allocation is an important part of any investing strategy. You’ve heard the adage “don’t put all your eggs in one basket.” That’s especially true in the stock market.
So, how many of your eggs should you put in the FAANG basket? It depends.
First off, you need to decide what percentage of your portfolio will be invested in equities and in safe-haven assets like fixed-income securities, if you haven’t done so already. A good rule of thumb to follow is to let your age represent your safe-haven allocation.
For example, if you’re 25 years old, you might invest 25% of your investment dollars in safe assets, leaving 75% to be invested in stocks.
From there, it’s time to determine how much of your stock allocation will be geared toward FAANG stocks. Another general rule of thumb is that you should never invest more than 5% of your total portfolio value in any single stock. Because there are only five stocks in the FAANG category, that means a maximum of 25% of your portfolio’s value should be invested in these stocks.
Keep in mind that 5% in each stock is a very aggressive investment. If you’re not quite sure about the validity of these stocks, or you would like to dial it back a bit for any other reason, you should invest less. Remember the 25% is a maximum, not a minimum.
Also keep in mind that, thanks to brokers like Robinhood, Interactive Brokers, and Charles Schwab, you’re able to buy fractions of shares based on the dollar amount you’d like to invest, rather than having to purchase a whole share. That comes in handy when your maximum allocation equates to less than the cost of a single share.
For example, if you have $10,000 in your investment portfolio, you should only invest a maximum of $500 in each stock. That makes adding one share of Alphabet, Netflix, and Amazon.com to your portfolio a problem because their share prices are all over $500 apiece. But with fractional shares, you can allocate up to 5% of your portfolio to these stocks and simply own a fraction of a share of each.
FAANG stocks are exciting investing opportunities. After all, nobody can discount the tremendous gains experienced by these stocks over the past five years.
While you may be ready to dive right into these names, keep in mind that research is the foundation of any wise investment decision. Even if you know the company well, take the time to look into what the company’s doing to continue on its path of growth prior to risking your hard-earned money.