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Long ago, I fancied myself a picker of internet stocks, creator of a 20-name model portfolio that called the bottom on the Web bust in August 2002. This list included Netflix at 86 (cents), Amazon.com at $14.90, and added Booking.com a year later at $35 or so.
With that in mind, I’m slumming in the old neighborhood thinking through what happens when Apple AAPL, +0.54% , Microsoft MSFT, -0.47% , Alphabet GOOG, +2.74% or Amazon AMZN, +0.69% break through the $1 trillion market-capitalization barrier for the first time in history — which could happen as soon as just after Amazon’s earnings report on Thursday, if it beats expectations.
We’re a long freakin’ way from 86 cents for Netflix NFLX, -1.95% . But the same basic logic applies.
BusinessWeek’s Web 20 portfolio was based on a few ideas. First, profitability was important, because it wasn’t taken for granted on the internet then, but valuation was less so. Management was an important screen, a lesson taught by watching people like Netflix’s Reed Hastings thrive while onetime-peer stocks like Overstock.com OSTK, -2.40% languished.
Then there were the related concepts of competition, market size and penetration — collectively, the most vital of all.
Back then, it was easy to pick the stocks — once you ignored how nearly everyone hated internet shares as a group. Many still believed Amazon would go broke, and Blockbuster would crush Netflix. E-commerce was a few percent of retail sales and U.S. online advertising was a $6 billion market — barely bigger than the fine that Alphabet’s now paying European regulators to make an antitrust dispute go away.
But if the internet, you know, happened — and my edge was that by 2002 I understood it was growing as fast as we’d projected in 1999, even as stocks had tanked — then profitability would take care of itself. Once it did, quality franchises and managers would win.
What does that playbook tell us about the FAANG stocks now?
First, and seriously: All six FAANG + Microsoft stocks (Facebook FB, +1.20% , Amazon, Apple, Netflix, and Alphabet’s biggest unit Google) are worth owning. I don’t own any directly, but through mutual funds I’m in all six, I’m sure.
But if you put a gun to my head, I’d buy Microsoft (now worth $833 billion), Facebook ($622 billion), Apple ($948 billion) and probably Amazon ($888 billion) first. I’ve got nothing bad to say about Netflix and Alphabet, but they’re slightly off the pace going forward.
First, the management screen is simple, since all the FAANG + M companies are well-run.
One can dislike Alphabet’s willingness to lose hundreds of millions on emerging businesses like Waymo self-driving cars, as it prints money from search-based advertising and YouTube.
But that’s vastly different than circa-2000 startups that burned tons of money, period. Netflix and Amazon make less profit than some value investors would like, but that’s because Hastings and Jeff Bezos have made investments they think will produce core-industry dominance. No fools here, either.
In place of 2002’s profitability screen, since major internet companies are all profitable now, I’ll substitute a valuation screen.
That hurts Netflix and Amazon, even though more-aggressive value investors like Bill Miller will defend Amazon’s value cred, thanks to its leading position in cloud computing. It helps Facebook and Apple, which trade at relatively modest price-to-earnings ratios of 28 and 18 on this year’s estimates.
Which brings me to the reason I’d eliminate Alphabet, Apple and Facebook from the running for the top pick of this elite litter — they’re in huge markets, but not the best market. The one that looks biggest and fastest-growing — with the most market share available for profitable pinching from incumbents — is cloud computing, the market led by Amazon and then Microsoft. Microsoft’s commercial cloud business grew 53% in the most recent quarter, and it has been gaining market share even from Amazon.
Netflix falls out of the race on valuation, with a price-to-earnings ratio of 245 and cash flow held back by producing hundreds of new shows and movies.
Facebook falls out because social-network advertising, while a big deal, isn’t the biggest unmined opportunity in tech.
Same with Apple and smartphones — its services play and other diversifications from iPhone sales are big, but not as big as the cloud. And smartphones are much closer to market saturation.
For Alphabet, assuming none of its moon shots hit soon, the maturation of search ranks it closer to Facebook than the best stocks in this elite bunch.
It’s really Amazon and Microsoft. I may regret this, because Amazon’s the cloud leader and tech history tells you to pick leaders and de-emphasize valuation. But their stocks are driven by similar businesses, one trading at 28 times earnings and the other at 284, and the cheaper one is growing faster in the business that matters. And that business is projected to top $400 billion in sales by 2020.
So I’ll pick Microsoft, a stock I never considered during its lost years under Steve Ballmer. Its turnaround under CEO Satya Nadella, who took over in 2014, is nothing short of stunning, most recently a killer performance in the June quarter. Nadella has made that one-time elephant dance.
Amazon and Apple, which reports earnings July 31, will likely get to $1 trillion first. But if I had to own one for the next two or three years, balancing risk and reward, it’s Microsoft.