Millennial Investors Favour Netflix and the Other FAANGs But Do They Understand the Risks?

One of the most renowned pieces of investment wisdom is the Warren Buffet tip to only buy stocks within your “circle of competence”. It is often also framed as ‘invest in what you understand’ and millennial investors, whether aware of the nugget or not, often follow it. Whether through more traditional online stockbrokers or via the new breed of budget app-only stock trading platforms, some of which invest spare change from purchases such as coffee into the stock market, millennials are naturally inclined towards the big tech stocks.

It shouldn’t be a surprise. Previous generations of retail investors were also attracted to the big brand companies they used on a daily basis such as BT, utilities and, more recently, Royal Mail. It is natural to presume that companies whose brands are prevalent within the society we live in and we ourselves rely on will be successful. As a result, the favoured stocks of today’s young investors are most commonly names such as Apple, Facebook, Amazon, Alphabet and Netflix – the FAANG stocks.

Millennials are not alone and institutional investors are also drawn to these high growth companies building technology empires. The group have been among the best performing big companies in the world over the past several years and have even become something of a safe haven for capital, attracting money nervous about the risk of a global trade war over the past few weeks.

But do the FAANG stocks favoured by millennials also meet the second criteria of Buffet’s advice that stocks should also have attractive values? The big U.S. tech companies all have valuations that represent multiples of current earnings far beyond those of peers in other sectors. Netflix’s price to earnings ratio is just below 250. This is based on the belief that these companies will continue to grow and increase their revenues. But is that still realistic and do millennials understand the risk that the companies they are investing in represent as well as the opportunity?

This week Netflix, one of the popular FAANG stocks, saw its share price plummet after it reported having missed a new subscriber target of 6 million in the second quarter, instead adding a little over 5 million. The company’s value immediately dropped by 13% as investors took fright, though by the following day a bounce back reduced that to around 6%.

The company, and analysts who back it, think it’s a blip and Netflix still has huge expansion opportunities in population-dense regions such as India and Japan where it is investing heavily in local content. More cautious observers such as GBH Insights analyst Daniel Ives say that the company’s share price is currently “on the top of the mountain right now. They are miles ahead of their competitors”.

However, Ives also believes that Netflix “have a bulls eye on their back”. Disney, for example, is expected to mount a strong challenge to the company’s dominance of the streaming market when it launches its own service next year. Amazon Prime is also not a threat to be discounted. So other than increasingly intense competition what are the other threats to Netflix that millennial investors in the company should be aware of?

Content quality and quantity is a delicate balance. Netflix is investing massively into original content, particularly that local to its big target expansion markets such as India and Japan. If the shows produced don’t contain some big hits that could hit the company hard, especially as it is using the junk bond market to finance much of it. There are also voices of complaint that Netflix’s catalogue of content produced by other companies needs to be improved to fully satisfy subscribers and could be a chink in the armour for new competitors such as Disney to go for.

Debt that Netflix has been building up to finance content is a concern that should be kept a close eye on. That’s especially the case given that the company announced this week that rather than issuing new equity, which many analysts believe would be cheaper, the company will add to its current $8.4 billion of junk bond debt with a new issue that would be expected to offer 6%. With the credit cycle turning as interest rates rise, Netflix’s junk bond load would be expected to start weighing on the balance sheet if it doesn’t turn cash positive within the next 2-3 years.

A tech stock bubble has been called by some with valuations at record multiples. In March a sharp correction stoked fears that the joyride was over for the FAANG stocks. The Facebook/Cambridge Analytica scandal and Trump’s attacks on Amazon raised fears that new data protection laws and a tax crackdown would hamper future growth. That proved short lived and the FAANGs have moved to new strengths as capital flowed back into them as a ‘safe haven’ from trade war fears. However, expensive valuations are always vulnerable and if markets lose even a little faith in growth prospects the landing for the whole tech sector could prove heavy.

ETF flows reversal is a final danger. Over the past decade more and more international capital has been directed into passive index trackers. That worked very well as markets went on a strong bull run. However, a less correlated market, anticipated on the horizon, would be expected to see a shift backed towards active stock picking. FAANG stocks have been particular beneficiaries of the flow of capital into index-tracking ETFs and a reversal of the trend would be expected to hit Netflix’s share price.

However, despite those risks to Netflix and the other big tech stocks favoured by millennials there is still a good chance that the focus of their investments could pay off. Most analysts still have price targets of between $450 and $500 for Netflix, against a current share price of just over $370. Expansion in Japan and India genuinely holds the promise of the company succeeding in significantly growing its subscriber base. Goldman Sachs analyst Heath Terry has forecast that international markets will contribute another 34 million subscriptions in 2019.

Barclays analyst Ross Sandler, quoted by Business Insider, maintains that this would strengthen the foundations of the company significantly. It would also mark a strong start to Netflix’s valuation moving towards something comparable to that of other media businesses rather than its current huge ‘growth tech’ multiple. On this methodology Sandler argues “the stock looks cheap” at its present price.

So perhaps millennial investors are, after all, taking heed of Buffet’s two-pronged pillar to investment approach by investing in their circle of competency in company with an attractive valuation. Investors in Netflix and other FAANGS would, nonetheless, be wise to not forget one more famous statement made by the Sage of Omaha back in 1996 on leaving a margin of safety when considering valuation:

“On the margin of safety, which means, don’t try and drive a 9,800-pound truck over a bridge that says it’s, you know, capacity: 10,000 pounds. But go down the road a little bit and find one that says, capacity: 15,000 pounds”.

The problem with investing is that different scales give different readings on how much the truck currently weighs.