Long fangs, Short fangs

June 17, 2016 03:00 PM

Joseph Parnes

Many traders and investors looking at the extreme volatility from “FANG” stocks: Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google (GOOGL) are tempted to find what appears to be visually appealing shorting opportunities. However, as is often the case, looks can be deceiving. 

Large institutions are heavily invested in FANGs with an expectation of a long-term growth holdings — based on the FANG’s collective, projected earnings and cash flow — shorting is not recommended. While the volatility might suggest that of a typical short — it is not. The sheer lack of liquidity available, low float and short interest will inherently squeeze and force cover, making FANG stocks candidates for growth accumulation or new lows. 

In taking short positions we typically put on a 10% to 15% stop loss, depending on volatility. The FANG stocks appear to be “overheating” from both a technical and fundamental perspective. Support and resistance levels have been challenged, gaps have formed and volume is higher. The long bull move in these issues may be getting old but doesn’t appear to be over. In fact, these tailwinds make FANG stocks a reliable buy going forward. 

While some factors may qualify FANG short selling, the compulsion to cover by the lender at any time unexpected stocks as a potential short, their volatility is so dramatic that the typical investor will face the “greatest fear” of subsequently erasing any gains normally expected, or worse. 

The reasons for avoiding the FANG as shorts stem from their immense reversal power, and the implied wider bid-ask spread that is manifested in these positions from large institutions to ETFs that appear to be holding them as long-term collateral with little intention to liquidate. Thus, with less liquidity and the potential for purchase becoming higher, the bid-ask will quickly dominate the short investor. In contrast to the larger players, even in a situation where they may be forced to cover, their disproportionate liquidity in the market affords them a protection not guaranteed to mid- to small-sized investors. This inherently binds such an investor from capturing the value of a typical short position and places a risk (literally like a gun to the head to cover) that is too great a consideration. If one would even consider naked shorting, the risk is exponentially more damaging. Additionally, regulatory agencies — often fearful of shorting in general — can make lending availability harder as they fear the companies’ devaluation could impact the market more broadly. 

The FANG’s one-year chart properly analyzed puts this risk in perspective, and as such, makes the FANG’s squeeze potential, analogous to a closing vice, better thought of as a holding for a long-term growth consideration. Using a variation of our strategy often coined as a “constrained long-short portfolio,” shorts should be included as a hedge using their proceeds to capture the momentum in conjunction with long positions. As an example, we’ll look at using a 130/30 model selecting long positions that equal up to 130% of the nominal capital invested and short positions that equal up to 30% of the nominal capital net market exposure of 100%. Under this technique, the proceeds are then applied from the FANG specifically for their long-term growth rate 
as these companies have enjoyed triple-digit growth earnings and less overhead expenditures. For all of these reasons, the extreme volatility, deviation and capacity in terms of float and liquidity, the FANG is simply not worth the risk of being squeezed. It’s not hard to find low hanging fruit as there are bountiful and ripe shorts in today’s market that are better suited.

Joseph Parnes, president of Technomart Advisors, currently is long all four FANG stocks.

Michael E. Lewitt

You say FANG stocks; I say Four Horsemen of the Apocalypse. I give them that name because if these four stocks ever stop rising, there would be one hell of an apocalypse in stocks. 

We are in a stealth bear market disguised by the performance of the cap-weighted indexes. Nowhere is the market’s bifurcation more apparent than in the rise of these Four Horsemen. Consider that in the first half of 2015 the FANGs plus Apple Inc. (AAPL) and Gilead Sciences Inc. (GILD) collectively accounted for more than 50% of the $664 billion in value added to the Nasdaq in those six months. If we substitute The Walt Disney Co. (DIS) for Netflix (NFLX), this line-up of six stocks had accounted for more than 100% of the $199 billion rise in the market value of the S&P 500 between Jan. 1 and June 30, 2015.

Almost a year later, all four FANGs have gained by double digits, and all four are even more egregiously overvalued. Of course, there are plenty of analysts and talking heads that are happy to cheerlead the big tech stock rise by making outrageous predictions that generate headlines but mislead investors. Now they are extrapolating strong first quarter earnings (except in the case of NFLX, whose earnings disappointed) into the future to justify these recent rallies in the stocks. 

To determine the likelihood of that, it’s best to look at the numbers instead of the pap the financial news channels feed their viewers to keep them tuning in and the advertising dollars rolling in. 

The four have a collective market capitalization of $1.21 trillion. The FANGs trade at widely divergent price/earnings multiples including cash (see “Tale of the tape”). The first three will require enormous revenue and earnings growth to maintain these valuations, while even Netflix will need to grow rapidly to maintain its stock price.

The most dangerous one for investors is Amazon, which has gained 63% in the last year and just hit new all-time highs above $700. It remains a great service company with a ridiculously overvalued stock. It has created a new model for capitalism, but in doing so, has destroyed not only its own profit margins but the profit margins of every company with whom it competes. It continues to generate extremely low earnings on a rising tide of revenues and expenses.

One hedge fund manager at the Sohn Conference in early May argued that Amazon will become a $3 trillion company by 2025 — 10 times larger than it is today. This is patently absurd. For Amazon to hit $3 trillion, the world population would have to triple. The lesson of Apple should serve as a stark warning to investors about one of the most important lessons in the investing universe — the law of large numbers. As these companies grow larger, it becomes increasingly difficult for them to maintain their sky-high growth rates. That is what is happening to Apple now and it happened to every other mega-cap company that held the crown of most valuable company in the world, including Exxon Mobil and Microsoft. Eventually, such large amounts of revenue and earnings are required to maintain enormous market caps that growth rates slow and stock prices drop. 
Investors need to ignore the breathless media coverage of these companies and use common sense, because they will plunge in value when the market finally fully comes to its senses. 

Michael E. Lewitt has no positions in FANG stocks.

About the Author

Michael E. Lewitt is a hedge fund manager and author who managed billions for institutional and high-net-worth clients over a 29-year career that started at Drexel Burnham Lambert. Now he runs the Third Friday Group. He also writes one of the industry’s most respected financial newsletters. His new book is “The Committee to Destroy the World.”