The FANGs Look Long in the Tooth; Rotation to Small Cap Under Way?

Much press has been devoted to the FANG stocks and their outperformance of the market over recent history. Pick pretty much any time frame in the last few years and the performance of each of the FANG’s, Facebook (FB), Amazon (AMZN), Google (GOOG) and Netflix (NFLX), has been significantly better than that of the S&P 500.

The strength in these shares, unlike the internet bubble of the late 90’s, is based on very strong fundamentals. The FANGs are each disruptive companies that are taking market share from older, more traditional, business models on a daily basis. To suggest that these companies are not going to be globally dominant concerns for years to come would be foolish.

The disruptive nature of these enterprises has also had a side effect of disrupting the field of investing. When you look at performance returns of this magnitude coming from very large companies, it can really affect the market overall.

To put it in perspective, over the last two years GOOG has been the “weakest” of the FANGs, only returning around 50%. This return is close to double the S&P’s 28% during this timeframe; a number that is certainly skewed higher by the fact that GOOG is the second largest component of the index, followed closely by FB at number 4 and AMZN at number 5. Together the FANGs comprise close to 7% of the 500 member index.

The result of several of the largest companies in the world putting up large annual returns year after year, a feat typically only possible for smaller capitalization companies, has been numerous changes to the world of investing. The largest of these changes has been the rotation from active managers to passive funds such as ETFs.

As I wrote about in December, the movement of massive funds to ETFs from active fund management will result in outperformance by the indexes and a correlated underperformance by stocks not found in these groups.

It’s a self-fulfilling prophecy and it played out well over the first half of the year. The FANGs did great, hedge funds shut down with managers finding it impossible to compete with ETFs, and, in general, the average person who didn’t have a portfolio invested in basically the largest companies in the world found the market to be much less ebullient than the indexes would have you believe.

The more things change, the more they stay the same…

One theme that remains consistent in the markets, throughout history, is cyclicality. When a group outperforms for too long, there is an eventual shift back in the opposite direction.

This doesn’t mean that the FANGs can’t go higher. They certainly can and their fundamentals suggest that you wouldn’t be too smart to bet against them. However, even when everything is going your way, share valuations can run ahead of fundamentals, leading to corrections.

Take the example of Cisco Systems. During the 90’s, this was THE stock to own. The internet buildout was booming and CSCO was the most direct beneficiary. From 1995-2000 the stock went from below $2 to over $57. However, it was not exactly a non-stop move for Cisco. During each of the years of 1995, 1996, 1997, 1998 and 1999 shares in CSCO had pullbacks of between 20 and 45%. The point being that nothing goes one directional forever, including THE stock to own as the most disruptive technology ever (the internet) came into existence.

Which brings us to today and the FANGs. This group has done exceedingly well, to the point where they are some of the largest stocks in the world and are massively owned by almost every investor, whether it be directly or through funds. If fund managers haven’t owned these, they have likely underperformed the market. Until August, that is.

The above chart shows the S&P 500 performance since August 1, compared to the FANG stocks. The S&P is hitting new highs on a daily basis, yet the FANGs as a group are not participating, with only one keeping up with the S&P, but trading below its recent high.

Rotation into small cap underway?

Despite the world being awash with capital these days, there still is only a finite amount of cash in investors’ hands. If you buy one stock, that means you can’t buy another. This was the case in the first half of this year as investors sunk their teeth into the S&P, particularly the FANGs, ignoring smaller cap stocks.

This trend is reversing. Simultaneous with the underperformance of the FANG stocks, the smaller indexes are acting great. Witness the strength in the Russell 2000 versus the S&P 500 over the last

Since the S&P 500 bottomed from early August selling, on August 18th, it has rallied over 3%. However, during this time the Russell 2000 is up close to 9 1/2%!

It is our contention that we are seeing a well-deserved rotation out of the over-extended large cap stocks, back into smaller cap growth. This trend is causing the lesser followed indexes to outperform the more heavily tracked indexes, like the S&P 500.

This trend is even more evident in looking at the LD Micro index, which is the best index for tracking very small companies, with the average market cap being $130M. This is a good benchmark for the Tailwinds Select Portfolio and it has been stronger than the Russell since mid August, rallying about 12%.

At Tailwinds we look for companies that have disruptive business models and are under-appreciated by the market. Sometimes they stay unloved for a long time, even if the underlying business is doing well. At other times, they will run on a broad based microcap rally even without news. It feels like, with a secular rotation out of the FANGs and into smaller cap underway, we may be on the verge of a nice stretch into year-end.