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What Are FAANG Stocks?

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Scroll down any major finance site, and you'll quickly see an article about "FAANG stocks." If you're new to investing, this might be very confusing. Are they talking about a company dealing with vampires or snakes?

The reality is much simpler. The acronym "FAANG" represents some of the biggest and most important tech stocks in the world -- the companies that make the gears of our everyday lives turn:

  • Facebook (NASDAQ: FB) -- the world's leading social media company, which also owns Instagram and WhatsApp.
  • Apple (NASDAQ: AAPL) -- the company behind the iPhone.
  • Amazon (NASDAQ: AMZN) -- which has ushered in the age of e-commerce and built a highly profitable cloud operation as well.
  • Netflix (NASDAQ: NFLX) -- the first and most successful video streamer in the world.
  • Google (NASDAQ: GOOG) (NASDAQ: GOOGL) -- technically, the search giant is now a subsidiary of Alphabet.

Why are FAANG stocks so important?

If you participate in modern American society, it should be pretty easy to see why these five stocks are so important. Many people start their day by looking at their iPhone (Apple) to see what friends and family are up to (Facebook) or check on the latest news (Google). They end their day by coming home to see a package waiting on their doorstep (Amazon) and go inside to binge-watch their favorite show via streaming video (Netflix).

Perhaps that's a bit dramatic, but you get the point: These five companies have fundamentally reshaped our daily lives. Not that you should need convincing, but consider the ubiquity of these players:

How have FAANG stocks performed?

Unsurprisingly, then, these five stocks have performed exceptionally well. In fact, they have been the key drivers of economic growth via the stock market since the last bear market ended on March 9, 2009.

At that time, Facebook was not yet public. The other four were -- and their returns have dwarfed the S&P 500 Index. Here's how they performed through the beginning of 2019.

For those keeping track at home, that's an average return of 2,900% in just a decade. A $10,000 investment spread evenly across these four was worth $300,000 10 years later. If you just invested in the broader market (the purple line) you'd have had a little more than $50,000.

Another way of looking at this is to say that these four have returned about 40% per year over the past 10 years. Facebook went public back in 2012 and has returned about 25% per year since then.

Of course, past performance doesn't mean there's a 100% chance these types of returns will continue. But looking back, no matter how you slice it, these five stocks have performed exceptionally well.

Today, the total market capitalization of all five stocks hovers near $3.2 trillion. That's more than the total economy of all but four countries -- the U.S., China, Japan, and Germany -- in the world.

Which FAANG stocks should you own?

Clearly, shareholders of these five stocks have enjoyed enormous returns. But the stock market is a forward-looking entity, and the important question is this: How many of these five stocks should you own moving forward? Since all of these companies are already so big, are their best growth days already behind them?

There's no definitive answer to these questions. For every potential investor in FAANG stocks, there are tons of variables to consider: age, lifestyle, appetite for risk, and income, to name a few. With each new set of circumstances, your approach will change.

For each company, we'll cover what I consider to be the most important factor: a company's moat -- its sustainable competitive advantages. Moats come in four broad varieties:

  1. High switching costs: This occurs when leaving a company for a competitor would be financially costly, too time consuming, or too much of a headache for the user.
  2. Network effects: With each additional user of a product or service, that product or service becomes more valuable.
  3. Low-cost production: When a company can offer a good or service that's just as good as the competition -- but at a lower price.
  4. Intangible assets: These include patents, government-regulated protection, and brand value.

Facebook

We'll start with the world's largest social media company.

Facebook has a very wide moat. It comes, primarily, in the form of network effects. In fact, no company is a better exemplar of network effects than Facebook. Each additional user of Facebook -- or its other properties: Instagram, WhatsApp, or Messenger -- makes the service more valuable. Who'd want to join a social network with no one else on it?

And while many are worried about the increased security spending, I think it actually becomes a long-term advantage for Facebook. Not only do competing social media networks need to produce something that's notably different, but they need to have enough cash on hand to provide the same level of security. Few have such resources.

Apple

Next, we have the world's most successful product designer...ever. What the iPhone has done in a little more than a decade is unprecedented.

Apple's primary moat comes in the form of its brand value. In Forbes' 2018 rankings, Apple had the most valuable brand in the world -- estimated at $182 billion. It's pretty easy to see this in action: People line up outside Apple stores for hours to buy the next iPhone, even when a much cheaper Android smartphone is available.

Apple has actually done a good job of building out additional moats around its business. iCloud's services and syncing of devices -- for instance -- represent a mildly high switching cost. It is, after all, pretty inconvenient to lose easy access to all of those files.

The company's App Store also benefits from network effects: As more people go to it to buy apps for their devices, third-party app developers are incentivized to build apps on Apple's platform. But at the end of the day, the brand is the thing. Without it, the other parts just don't work.

That's a very important factor to be aware of. The value of a brand can be fickle. Apple achieved its greatness during the Steve Jobs era, when the company was creating products -- the iPod, iPad, and iPhone -- every few years that we didn't know we needed so much.

Since Jobs's unfortunate passing, Apple hasn't innovated the Next Big Thing. So far, that hasn't stopped the company. But it's worth remembering that the competition is fierce, and Apple's primary moat is narrower than those of the rest of the companies in this group.

Amazon

If it seems as if you see those Amazon boxes on everyone's doorstep, you aren't imagining things: the company is estimated to own half of all e-commerce sales in the United States.

Personally, I'm a big believer in the stock -- it's my single largest holding, and that all has to do with the massive moat surrounding the company. Let's review:

  • High switching costs: While this isn't the most powerful of the four, the deal that customers can get with Amazon Prime is simply unmatched. Between free shipping, access to digital content, and a host of other Amazon Prime benefits, there's no way you'd find a better deal by switching away from Prime.
  • Network effects: Amazon is the No. 1 destination for online shoppers. Vendors know that. So they are willing to list their stuff on the site and use Fulfillment by Amazon. That, of course, simply draws in more consumers -- which attracts more vendors. It's a virtuous cycle.
  • Intangibles: The biggest intangible benefit to Amazon is its brand value. Forbes rates it as the fifth most valuable in the world, at just under $71 billion.
  • Low-cost production: This is -- in my opinion -- the strongest moat. Amazon has a network of 138 multimillion-dollar fulfillment centers domestically and another 160 abroad. This allows the company to get products to customers faster, and at a lower internal cost, than the competition could ever hope to match.

Another enormous factor to remember with Amazon is the company's optionality. This is another way of saying that there are tons of different ways to accomplish Amazon's ultimate mission: to be earth's most customer-centric company.

That's the only way you could explain what Amazon has become to someone traveling to the present day from 1997. "An online bookseller has become the world's biggest e-commerce store and the leader in computing? What in the world?" You can imagine the confusion.

But that's what happens when your sights are set on such a broad goal. Most everyday Americans, for instance, might not realize that the bulk of Amazon's profits actually come from Amazon Web Services (AWS) -- not e-commerce. That part of the business is protected by high switching costs (while people can switch away from AWS, it's a pain), and network effects (the more people on AWS, the more data it can collect, and the better its AI efforts perform).

Who knows which industry will be the next to be disrupted?

Netflix

Who doesn't know Netflix? It's kind of mind-boggling that just 10 years ago, streaming was only a test project for Netflix. Those red envelopes were really the main part of the business. Today, they're an afterthought.

Netflix's moats mostly fly under investors' radar, even though they benefit from them significantly. The company uses its brand to get customers in the door and has sneaky-high switching costs that keep them there.

The most important factor in getting new subscribers is having great original content. If the only place you can watch something is on Netflix, you'll have to join. And given that the company's performance at the Oscars continues to turn heads, things are going well here.

Then there are the high switching costs. No, the switching costs really aren't that high. But when your monthly payments are auto-billed to your credit card, you barely even notice what's happening. That means that barring enormous price hikes or terrible PR coming from the company, current users will likely be future users for life.

But there a few caveats worth noting that don't have to do with the company's moat. Chief among them: Netflix has been spending hand over fist on original content. Given that the company's brand is how it draws subscribers in -- and that the brand is powered by the original content -- such spending makes sense.

That's only the case, however, so long as Netflix continues to produce popular shows. Investors need to keep an eye on the quality of original content as well as the balance sheet and cash flow statement.

At the end of 2018, Netflix had a cash position of $3.8 billion but a long-term debt load of $10.4 billion. Additionally, it lost $2.85 billion in free cash flow during the year. That's not sustainable -- and the trends need to eventually reverse for Netflix to remain a good investment.

Google/Alphabet

Finally, we have the owner of the world's two most popular websites: Alphabet. Unsurprisingly, Google.com is the No. 1 destination in the world. But did you know that Alphabet also owns YouTube.com -- the second most popular site?

The average Internet user spends 17 minutes every day on these two sites combined. That might not sound like much. But over an entire year, that's 103 hours on these sites -- multiplied times billions of Internet users.

For Alphabet, that moat comes in the form of low-cost production. What does it produce? Data. And in today's connected world, that's like striking oil. If you remember from the start of the article, Google has eight products with more than 1 billion active users. Once set up, these tools don't require onerous investments -- they just bring in data for a lower cost than anyone (except perhaps Facebook) could ever dream about.

But there's an added benefit with owning shares: Alphabet is devoting a safe amount of capital to high-risk, high-reward moonshots. Many of these projects will fail, and that's OK. All it takes is for one moonshot to be a hit, and the company could gain a huge boost in revenue. Already, it's becoming clear that Waymo -- Alphabet's self-driving vehicle initiative -- could be the first big hit.

But that's not the only moonshot of note. The company is trying to give wireless access to remote areas of the world (Project Loon), protect people from advanced cybersecurity threats (Chronicle), and develop autonomous drone delivery (Wing), to name a few.

Owning Alphabet shares, as I do, gives you exposure to both the wide-margin data-and-advertising business while also getting the upside from the moonshots. To me, that's a great deal.

Are there risks to FAANG stocks as a group?

You might look at these five companies and think: "They're all technology companies. I don't want too much money in the technology sector!"

That view is both correct and short-sighted. Yes, all five of these companies use technology that didn't exist just 25 years ago. But the same is true for almost every other company on the public markets.

If you're worried about putting too much money into these five stocks, here's an easier way to view what these five players really are:

  • Alphabet and Facebook are advertising companies.
  • Apple is akin to a high-end fashion company.
  • Netflix is an entertainment company.
  • Amazon is a little bit of everything: retailer, marketplace, shipping specialist, and, increasingly, also an advertising outfit.

The bigger risk investors should be aware of is that four of these five have recently landed in the crosshairs of politicians and regulators. Netflix isn't considered a monopoly by those most concerned about FAANG stocks' antitrust issues, but the other four are. Apple might seem an odd inclusion here, but the company's practices in the Apple App Store have drawn ire from some critics.

While it's never a good idea to make investment decisions based on what politicians may or may not do, it's good to enter any investment with eyes wide open.

Should I buy FAANG stocks now?

All told, FAANG stocks are an enormous part of many portfolios. Does this mean you should run out and devote most of your money to these stocks? Hardly.

If you're interested in FAANG stocks but don't yet own any, I suggest you take an approach that allows you to ease in over time. Let's say Amazon is your favorite stock of the bunch. Then I suggest allocating, say, 2% of your portfolio to it now. You can add more later if you feel comfortable with that move.

That might sound like a boring approach. It requires time to deliver stellar results, and no one gets excited about waiting. But it's also effective, and it helps guarantee that you don't put too much behind a stock before getting to know it.

There's also no guarantee these companies won't be disrupted. That is, after all, how they became so successful in the first place: by disrupting the market leaders. They've done so well that they now have the bullseye on their backs.

All of that said, I think every investor should carefully consider devoting a reasonable part of their portfolio to FAANG stocks. They are market leaders for a reason, and they represent some of the finest businesses America -- or the world -- has ever known.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, and Netflix. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, and Netflix. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.