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Willie Sutton was a famous bank robber during the 1930s. When asked why he robbed banks he reportedly replied, “Because that’s where the money is.”
Its been the no-brainer stock trade of the decade – buy and hold the tech aristocracy often referred to as FAMAG (that’s Facebook, Apple, Microsoft, Amazon, and Google). They have outperformed the S&P 500 by 155% since 2013. Their share of the SPX in market cap terms has swelled from less than 9% to 22% in the past seven years, with a fifth of that gain coming since October 2019 (Charts 1a and b).
It’s easy enough to make the case for upward and onward. These companies are at the crossroads of the digital economy, beneficiaries of technology monopolies and all-but infinite networks, juicy margins, piles of cash, and perhaps most importantly, first dibs on the best and brightest talent globally.
What is there to stop them? The vultures have been circling for years to little effect. The European Union has had the most success, defining digital rights and giving people some control over their data, and taxing digital services. But despite much rhetoric, no one has been able to come up with an anti-trust or anti-monopoly framework to weaken their dominant market positions. Indeed, the coronavirus crisis has highlighted how essential these companies’ services are in today’s society. If equity valuations mean anything, their dominance has become even more absolute in 2020.
Can Today’s Sure Thing Stay That Way?
But that same crisis could also spell the beginning of the end for the laissez-faire regulatory environment that allowed the FAMAG companies to thrive. We see a variety of issues and warning signs that could become a drag on FAMAG valuations in the foreseeable future.
It’s All About Revenue Now
The most immediate threat may come from governments around the world that are battling the coronavirus crisis and watching budget deficits balloon as expenses soar and tax revenue collapse. Soon enough, they will be following Willie’s advice and going where the money is.
These days that won’t be the banks – rather the more likely target will be Silicon Valley and the FAMAG tech aristocracy. It’s not just because they have more money or earn monopoly profits. A starting point is that they simply don’t pay their fair share in taxes. The federal corporate tax rate in the US is 21%; most states also levy a state corporate tax, making for an average tax rate of 25.7%. As the table below shows, only Facebook paid an effective tax rate near this level for fiscal year 2019. Effective tax rates for FY 2018 and trailing 12 months are broadly similar.
Before the corporate tax rate was cut from 35% to 21% in 2017, FAMAG companies (and many other S&P 500 companies) enjoyed effective tax rates well below the statutory rate due to various tax preferences. The Tax Cuts and Jobs Act of 2017 did little to close these loopholes. Simply eliminating these preferences so that companies pay roughly a 25% tax rate could increase the tax revenue from FAMAGs by $18 billion and from the S&P 500 companies by $80 billion (see table below). These numbers hardly seem material when the federal budget deficit is projected to be $3.8 trillion in 2020, and well over a trillion dollars annually for years to come. But when the time comes to start dialing for dollars this could be an easy win for politicians and likely popular with rank-and-file voters.
*SPX data reflects Macro Hive estimates
For investors, the most relevant number in this projection is the last column with the pro forma percent change in net income. Assuming P/E ratios stay constant, FAMAG stocks could collectively fall 11.4% and the SPX could drop 6.2%. If the all-in tax rate were 30%, equities could drop another 6 percentage points at constant P/E ratios. To the extent a higher tax rate reduces stock buybacks or business investment, the hit to P/E ratios and stocks could be larger.
Public Utility Role Coming?
The coronavirus crisis has highlighted both how critical internet infrastructure and FAMAG services are and also how unequally they are distributed across society. One obvious example is that, as schools around the world closed and turned to online learning, students who lack internet access or computers have been cut off from the virtual classroom. And, as millions of people have had to work from home, many have found that their residential internet service is often less than robust.
Even if schools were to reopen and people return to the office this fall, the coronavirus has exposed a need to address these shortcomings. Improving internet infrastructure is the province of internet providers. But rather than force them (and their subscribers) to foot the entire bill, one could imagine a scenario where some enterprising politician or regulator requires FAMAG companies to subsidize this work on the theory that the infrastructure is critical for delivery of their services and so they should pay a user fee.
Likewise, FAMAG companies could be pressured or required to support public education by subsidizing the purchase of laptops and related equipment in less affluent school districts. The rationale would be that the digital economy requires an educated workforce and an educated population benefits the FAMAG companies.
In essence, FAMAG companies would become a form of public utility in this scenario, where monopoly profits (or economic rents) would be siphoned off for various social purposes.
Copyright Laws May be Changing
For more than a decade now, FAMAG companies (FB and GOOG) in particular have been attracting advertising dollars that used to go to newspapers and other print media. Ironically, they have done this in part by using their search engines to aggregate and present on their platforms news stories prepared by traditional media outlets. In most cases, these websites provide a summary of the story and link to the original – but critically, the aggregator gets the first opportunity to present ads to potential readers. Copyright laws today are such that aggregators do not have to pay for featuring content produced by others. That loss of ad and royalty revenue has caused many news organizations to drastically cut regional and local news coverage.
Alarmed by this trend, Australia and France have taken the lead in forcing FB and GOOG to find a way to share ad revenue with news publishers or face regulatory requirements to do so. Spain tried to impose a similar requirement on GOOG a few years ago but GOOG responded by simply shutting down its Google News site in Spain. GOOG tried a similar tactic in France but was told that would constitute an abuse of market power.
This is work in process, but if Australia and France are successful other countries are sure to follow.
The bigger risk is that if news organizations are able to get a share of FAMAG ad revenue, other types of content providers whose work is featured on FAMAG platforms will start agitating for a share of ad revenue. After all, if their platforms don’t provide access to interesting content who would use them?
A Section 230 Revisit?
The FAMAG platforms have come under increasing criticism for fraudulent information posted on their platforms. Among other things this has taken the form of fake news and misinformation to influence elections; publication of counterfeit or plagiarized books (Amazon); and fake businesses to scam consumers (Google Maps). We discussed this problem in a MacroHive article last year.
The FAMAG companies have avoided liability for content posted on their platforms thanks to Section 230 of the 1996 Communications Decency Act, which provides a safe harbor for distributors of content (such as bookstores, newsstands and internet platforms) from being sued over what they distribute. They can remove materials that are harmful or fraudulent but are not obligated to review every posting or to take action.
There is growing risk that FAMAG companies could be required to monitor content posted on their platforms, especially if the public utility argument that their services are essential takes hold. This would expose them to higher costs and litigation risk.
Anti-trust is the Biggest But Least Likely Threat
A centerpiece of Elizabeth Warren’s presidential campaign was a call to break up the FAMAG companies. Both the Federal Trade Commission and the Justice Departments have ongoing anti-trust investigations of FB and Amazon, respectively, and the Justice Department is expected to sue Google later this year.
While many, indeed probably most, would agree that the FAMAG companies are de facto monopolies and wield too much market and political power, trying to break them up seems largely a quixotic quest under today’s anti-trust law – at least in the US. There are laws and statues that address most forms of market abuses, but the only approach that holds water in the US is unfair business practices that cause prices to be higher than they would otherwise be. It is difficult to make that case when FAMAG companies provide many services to the public ‘free’. Certainly, the track record for bringing anti-trust cases against major companies including AT&T, IBM and MSFT over the past 40 years not been less than encouraging. These cases have each taken years, cost billions of dollars, and hardly accomplished what prosecutors set out to do.
Still, the FAMAG companies are erring on the side of bringing this headache on themselves. When ZOOM suddenly became the go-to video conferencing standard during the pandemic lockdown. GOOG responding by offering its premium subscription video service (Google Meet) for free, and even going so far as to embed it in Google Mail.
Any anti-trust cases against FAMAG companies are sure to also take years, and cost billions of dollars. This isn’t the place to try to handicap how they might turn out; suffice to say for now that anti-trust lawsuits are unlikely to have much impact on FAMAG valuations for the foreseeable future.
One big problem is that much of the FAMAG success is built on network effects, which falls through the cracks of current anti-trust statutes. A further public policy problem is that if these companies were to be broken up, there is the risk that much of those network effects evaporate, along with the funds that might otherwise be available to pay taxes and subsidize various public policy initiatives.
Concluding Remarks
Our intent here is not to take a position on how or whether FAMAGs should be regulated in the future, or for that matter whether they can continue to soar, but rather to highlight emerging issues that could clip their wings in coming years.
FAMAG companies are flying high now because of their dominant market positions and margins. Even as coronavirus crisis obscures the outlook for most industries and companies, it has also highlighted the ability of these companies to print money during both the best and worst of times.
But that very ability also makes them a tempting target for governments and regulators looking for revenue to fill budget holes and accomplish various public policy goals. The coronavirus crisis could embolden them to implement what previously had been restricted to the fantasy realm of theory and nice ideas. Needless to say, what happens will depend critically on how elections go over the next year or so, in particularly in the US later this year and Germany next year.
Today, investing in a portfolio of FAMAG and related companies may appear to be as close to a sure thing as they come. But investors would do well to bear in mind the standard disclaimer that comes with any investment advice – that past performance is not an indicator of future performance.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)