Stockwatch: should you copy Fundsmith and buy this FAANG stock?

Do share price falls offer a selective opportunity for canny investors to take advantage of the US big tech crash, asks our companies analyst.

Leading global fund Fundsmith Equity bought into Alphabet (NASDAQ:GOOG) lately, raising a key tactical question: can ‘buying the dip’ still work in an environment of rising interest rates?

Since the 2008 crisis – although some economists might argue well before it – US monetary policy has been exceptionally easy, which has kept interest rates low and boosted growth stock price/earnings (PE) multiples. What philosophers call “the dilemma of inductive thinking” arises as a consequence, as in the example of the happy pig that assumes the arrival of the farmer each day means it will be fed, until one day it’s slaughtered instead. 

From a companies perspective, the question arises as to whether big cap US tech firms especially have had such a good run - helped by the pandemic - that an extent of consolidation is likely, both in operations and in stock performance. 

Bulls argue that these stocks can still demand high ratings because the companies dominate their markets, although I would bear in mind regulatory risk. 

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A prime example of the current challenge  

Alphabet’s fourth-quarter 2021 results achieved significant revenue and especially earnings beats, indicating its key Google subsidiary is thriving well in both the pandemic and an inflationary environment.

A trailing PE in the high 20s does not look overvalued when earnings may be growing at around 30% and regulators to date appear supine towards Google’s strengthening grip on the digital economy. 

There is tactical significance in the way Fundsmith has abandoned a sceptical stance on Alphabet, and also on Amazon (NASDAQ:AMZN). Certainly, its number one holding – Microsoft (NASDAQ:MSFT) – has been a long-term winner.  

But the sixth-largest holding, PayPal (NASDAQ:PYPL), is down 29% this week, and at number eight Meta Platforms (NASDAQ:FB) is down 26%, after both stocks missed earnings targets. 

The consensus of analysts had been overwhelmingly bullish on both, and their drop illustrates the problem with treating any stock as royalty.  

Morgan Stanley cites lower returns in tightening cycles 

Last Monday, the investment bank published long-term analysis showing how average equity returns during monetary tightening cycles are less than a quarter of their value in easing cycles. 

The question is whether the sheer strength of companies such as Microsoft, Amazon and Alphabet makes it ‘different this time’, enabling them to defy the classic headwind to growth stocks, rising interest rates. 

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Possibly, central bank rates would not rise to more than 1-2% anyway for fear of causing a debt bust and recession. If inflation remained engrained over 5%, investors would want to own companies with relative freedom to price.  

Fundsmith had previously been intrigued by Alphabet, yetits assessment of 235 acquisitions showed them failing; indeed, the latest results show “other bets” with negligible revenue and a $1.1 billion loss. For now, Google’s momentum appears to overcome any such worry. 

Will Google reign supreme as an internet search engine? 

This, to me, is the key issue, comparable with the iPhone’s importance for Apple (NASDAQ:AAPL). Apple used to be criticised as a somewhat one-product company, but the iPhone’s quality has helped Apple retain a number two position to Samsung in the global smartphone market, and with significant freedom to price.  

While I use the Microsoft Edge browser on a PC and it regularly asks me to default to its Bing search engine, I retain Google for searching due to its accumulated information – for example product and experience reviews. Google thus constantly shifts its advertising pitches to me, according to my search interests, and I hardly see this changing. 

The Mi Browser on my Chinese Xiaomi smartphone is very capable, but I have still downloaded Google to look things up and use the Maps app. Yet the next generation counts and Xiaomi is the world’s fastest-growing mobile device maker with 29% growth in market share to the global number three position. 

From Alphabet’s current numbers Google would appear unassailable, and the same is true in terms of digital advertising, which represents the future. The situation is again somewhat akin to Apple by way of rivals snapping at its heels and Apple lately showing better progress in diversification. Can Alphabet do the same?

Exceptional growth rates are going to slow 

Diluted earnings per share (EPS) rose 38% over the fourth quarter of 2020 – a 12% beat on expectations - but for 2021 overall soared a remarkable 91%. Quarterly revenue rose 32%, amounting to a 4% beat, or 41% annually. Growth rate percentages are also up on those for 2020. 

However, the acceleration in online advertising will have benefited from the pandemic – if likely a permanent shift – and also from US government cash hand-outs boosting consumer spending. Pixel phones are justifiably selling well and the cloud business is growing strongly. 

A potential argument in favour of Alphabet, and also Microsoft, as capital growth stocks able to morph towards superior income is their huge global reach, combining with a subscription model for cloud and Microsoft Office services. Once people and companies accumulate a lot of data with one cloud provider, they are unlikely to change. 

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But this has yet even to translate into a dividend for Alphabet, while due to the expansion of its PE rating Microsoft’s yield is an immaterial sub-1%. They are not unlike PayPal and Meta Platforms in the sense that as soon as high growth rates start to fade, stock multiples will contract. 

That is why I wrote on Alphabet last July with a “hold” rating at $2,730, versus $2,853 currently. I respected an operating margin well over 30%, was in two minds as to the absence of regulatory checks, and was wary about a looming shift from exceptionally low interest rates to a rising rates regime. 

Yes, buyers of big cap US tech on January’s drop initially felt good as February brought a rebound and bumper results for Alphabet. Yet the way the stocks are falling again suggests sentiment is not immune to the shocks from PayPal and Meta Platforms. 

Alphabet Inc - segmental analysis

A potential ‘buy’ if stock markets tank in a conflation of fear 

On a long-term investing view, I cannot share Fundsmith’s enthusiasm for Alphabet or indeed other big cap US tech. But various dangers are coming together and may potentially offer a buying opportunity in international blue-chip stocks.

Central banks are cornered by the need to tame inflation without significantly higher interest rates causing a debt bust. The Ukraine crisis has no landing strip in negotiations, and military build-up continues. It is said that sanctions like never before will deter President Putin from military action; but featuring also in his calculations will be a likely further jump in commodity prices and extra hurt to the West. In that case Russia will benefit from its substantial capability in oil, gas, metals and grain. 

Should stocks slump in the months ahead, if you can judge the point of maximum fear, then yes, Alphabet and other prime US tech stocks would be worth buying.   

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Stock split may also generate upside  

Be aware also, of a 20-for-1 stock split in July. Every time I see this happen with a successful “heavy” stock, it then rallies despite the split having zero effect on underlying value. The market is not necessarily sage, and with shrewd timing you could exact a trading profit this summer. 

If I were pushed into a corner for a single overall stance, therefore, it would remain “hold” – but there is a case also for selling as monetary policy tightens. Moreover, Alphabet fans ignore the risk that 2021 could have been an exceptional year, and also that of potential regulation. The stock's risk/reward profile is becoming complex.   

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.