Portfolio management is somewhat like gardening. Just as you need to prune your garden to keep if flourishing, so must you prune your portfolio. You need to pick through your holdings, isolate the underperformers and determine whether they are flowers to be nurtured or weeds to be removed.
In a narrow market, however, pruning a growth-oriented portfolio can be challenging given market leaders’ prominence in benchmark indexes. I believe that’s why we’re seeing unusual responses to earnings announcements in 2018. Normally, you’d expect strong earnings to lead to higher stock prices. But things are different when essentially everyone in the large-cap growth space owns—indeed, almost has to own—the market leaders. In this market, if you haven’t owned the handful of stocks that have led, you’re lagging the benchmark and your peers. Period.
But with the FAANG stocks at all-time highs, it’s no wonder to us that growth managers appear to be ready to take any opportunity they can to trim their positions. Check the holdings of large growth funds, and you’ll often see 8% or more of a portfolio invested in one or more of the FAANG stocks. That can get uncomfortable for portfolio managers seeking to maintain diversification. So on any good news—the kind that nudges the stock price up further—holders of these stocks are trimming their portfolios. After all, many portfolio managers don’t want a single stock creeping into the 15% range—especially with valuations as extended as they are now based on historical standards.
The upshot is that strong earnings reports just aren’t translating into meaningful surges in stock prices, which further reinforces market narrowness—something already to be expected in a mid-cycle economic expansion. Narrowness makes it all the harder to find attractive opportunities apart from the well-known leaders.
But that doesn’t mean you can rest easy and just keep riding those leaders blindly. There will come a time when the market will correct. And at that time, you have to be ready to aggressively shift your assets into the names you’ve already identified as the best quality. You have to know in advance which are the flowers to cultivate (even during a correction) and which are the weeds that should be removed for the overall health of the portfolio.
So let’s look at Amazon (AMZN). Is it a flower or a weed?
A key factor in determining if a stock is a flower or a weed is its stock price movement relative to the market. A stock’s strength relative to the market as a whole is the most basic measure of whether market participants—including all insiders and experts of various types—perceive a company to have an advantage. At its most basic level, relative strength suggests that someone somewhere knows something promising about the company.
Amazon’s relative strength to the market turned positive in October 2017, as the stock price gapped up on a solid earnings report. Relative strength continues to be strong today.
Positive Growth Catalysts
There’s nothing unfamiliar here, but it’s essential nonetheless. Amazon is a retail disruptor with the capacity to destroy competition as it moves into a sector. And it’s still underpenetrated. Amazon represented 4% of all U.S. retail sales in 2017, and 44% of U.S. e-commerce sales—plenty of room to grow. Amazon leads competitors by a wide margin in artificial intelligence. And its Prime program keeps customers coming back.
The big concerns are:
- Government regulation—antitrust concerns.
- Stock implications of an earnings miss.
- Increasing competition in AMZN Web services, a big source of profits.
- The stock is over-owned in most growth portfolios.
Stock prices tend to follow the long-term trajectory of earnings growth. Amazon’s earnings growth and its stock’s relative strength put it clearly in the “flower” category. Based on average analyst price targets the stock has a $1,880 value or an implied investment return of 9.9% based on today’s value of $1,717. An estimated advance of 9.9% may not sound like much compared to the doubling and tripling we’ve seen among market leaders, but it’s still higher than average.
Bottom line: Yes, Amazon is over-owned. Yes, its valuation is extended. But it’s still a flower to cultivate, not a weed to be pulled.
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Past performance does not guarantee future results.
FAANG is an acronym for the market’s five most popular and best-performing tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
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