Bottom Line: You can profit from the hidden value in these stocks
Legendary fund manager Bill Nygren has been a bargain hunter his entire career, scooping up shares in companies at dirt-cheap prices and holding them until the rest of the market wises up. But lately, his stock picking has raised eyebrows because his choices include high-fliers such as Facebook, Netflix and Google parent Alphabet Inc. Many investors consider these to be fully valued at best and grossly overpriced at worst—even after Facebook and Netflix share prices plunged in July, partly in reaction to disappointments over user growth.
Nygren, however, insists that despite still-lofty share prices and valuations, some high-fliers actually are modestly priced. Nygren, a dedicated value investor, believes that the economy and stock market have fundamentally changed. He says that to find the best opportunities, investors need to be willing to expand their idea of what’s undervalued.
Bottom Line Personal asked Nygren, one of very few large-cap value managers to beat the Standard & Poor’s 500 stock index over the past decade, how investors should evaluate popular growth stocks and which are the most attractive now…
Over the past decade and a half, forces such as the digital revolution—including the Internet and smartphones—have radically changed consumer needs and preferences, as well as the types of businesses that dominate our economy and stock market. I realized that the traditional measurements I was using (such as price-to-earnings ratio and price-to-book ratio) weren’t very effective at evaluating these “new economy” infotech companies, which operate differently from old-economy companies such as manufacturers, utilities and energy companies.
For starters, infotech companies don’t have a lot of physical assets on their balance sheets to evaluate. Most of their value derives from intangible items such as patents, software algorithms and intellectual property.
Second, infotech companies are more focused on attracting as many customers as possible than on growing earnings. That’s because competition is so fierce in infotech that businesses dominate by rapidly building market share. To do that, they will “undercharge” or even give away some of their products and services for free for many years. This is partly how Amazon and Google, for example, became the behemoths they are.
In the past, I was wary of fast-growing infotech companies with high stock prices relative to their earnings per share. But once I started looking to see whether they had moneymaking assets that weren’t showing up on their balance sheets, some began to look attractive even to an old-fashioned value investor like me.
My favorite infotech stocks that only seem expensive now but actually provide good value…
Price-to-earnings ratio (P/E): 50 vs. an overall average of 24 for companies in the S&P 500. The parent company of Google runs the world’s most dominant search engine and makes almost all of its revenue from online advertising sales. Alphabet is the second-largest holding in my portfolio.
Why I believe it’s undervalued: Traditional valuations ignore the vast potential of Alphabet’s other businesses. Examples: Alphabet acquired YouTube, the video-streaming company, in 2006 for $1.65 billion and turned it into a powerhouse that’s growing 40% annually in total number of hours viewed, while traditional TV and cable-TV viewing are in decline. But YouTube is ignored by value investors because it’s only marginally profitable. That’s because, in exchange for rapid growth, Alphabet decided to keep most of YouTube’s content free and to not embed as many ads as on traditional TV. If YouTube started charging viewers for basic services, viewership would drop off, no doubt, but revenue would increase, and the move would add several hundred dollars per share to Alphabet’s stock price. Alphabet’s self-driving car business, Waymo, is losing money now. But Waymo, which started in 2009, had a head start on its competitors and is well-run. Waymo plans to deploy tens of thousands of self-driving vehicles as taxis throughout cities in the US within a few years.
P/E: 27. As much criticism as it gets, Facebook still is the world’s largest online social network, with more than two billion monthly active users. The massive amounts of data Facebook collects from its users have made it the most sought-after and effective platform for online advertisers. I first invested in the stock after it dropped more than 10% this past March following a report that a political research firm with ties to Donald Trump’s presidential campaign was able to access the personal information of millions of Facebook users without their consent. I reasoned that this was a temporary setback that would cost Facebook no significant loss of users or revenue in the long run. Even if Congress made good on threats to increase privacy regulations surrounding social networks, that would help add to Facebook’s domination of its industry by helping to shut out new rivals.
Why I believe it’s undervalued: Facebook also runs businesses whose values haven’t been monetized. Example: WhatsApp is a free messaging service independent of Facebook and is used by one billion people daily. The service allows people to send messages and videos and make calls. A similar business in China—WeChat—has one billion users, and it generates $800 million in annual revenue by selling ads and games. Facebook’s other messaging app, Messenger, has 1.2 billion monthly users. The company plans to monetize that service by turning it into a kind of Yellow Pages for the Internet, charging a fee to businesses that want to message users directly.
P/E: 153. Netflix, one of the world’s largest video-streaming services, is the stock in my portfolio that raises the most questions, no doubt because of its seemingly exorbitant valuation. I, too, was skeptical. But Netflix’s intangible assets at this point are so potentially lucrative that the company can do well even in the face of competition from media giants, including the newly merged AT&T/Time Warner and The Walt Disney Co., which plans to launch a streaming service in 2019.
Why I believe it’s undervalued: Netflix has intentionally undercharged for its services for years to grow its customer base by 20% or more annually. If Netflix bumped up its monthly rates by a few dollars, the resulting spike in earnings would drop the stock’s P/E to the average P/E level of companies in the S&P 500. More important, the winners in streaming video in the future will be companies that do the best job offering content that consumers want to watch. Netflix has more global subscribers than the entire US pay-TV industry and expects to have 200 million by 2020. That kind of scale means it will continue to outspend everyone else for programming. Netflix already spends more on nonsports content than any other network, and it is expected to increase content spending by 25% this year while producing 80 feature-length films.
