There’s been much hype around the ‘magnificent 7’ as called but, says Chris Ainscough, portfolio manager and director of Asset Management at Charles Stanley, the changing fortunes of these companies makes a reappraisal is necessary.
Finding the right approach to the US market in the year ahead is complex. Markets have been led by the ‘Magnificent Seven’, but this is becoming an ill-fitting moniker for a group of companies whose fortunes are increasingly disparate. Valuations elsewhere in the market look more appealing, but earnings have been less exciting. This environment requires some caution.
The fortunes of the US market have become synonymous with the trajectory of the Magnificent Seven companies – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. They generated around 90% of index returns for the S&P 500 in 2023, with the remaining 493 stocks in the index largely forgotten. They are huge businesses, a significant share of the index and it is difficult to replicate this type of exposure elsewhere. As such, they cannot be overlooked. However, they need to be reappraised from time to time.
First, it is worth noting that the Magnificent Seven has now dwindled to four or five. With great hope comes great expectation and these companies are dividing into those that are delivering on the lofty expectations set for them, and those that are not. In its fourth quarter results, Nvidia, for example, reported a 265% increase in quarterly revenues, far exceeding Wall Street expectations. Founder and chief executive Jensen Huang said: “Accelerated computing and generative AI have hit the tipping point”.
At the other end of the scale is Tesla. Its share price has been sliding since the summer, and is now 22% below its level at the start of the year, in spite of relatively buoyant markets. It faces multiple challenges, including slipping growth for electric vehicles, and increasing competition from Chinese EV maker BYD. It warned in January that sales growth in 2024 would be “notably lower”.
This polarisation is not as acute elsewhere among the Magnificent Seven, but there is still a gap of 151% between the share price performance of Meta and Apple over the last 12 months. The market is becoming increasingly sensitive to earnings, and to the gap between expectations and reality on artificial intelligence. It is clear that some companies are monetising AI successfully and others are not. Investors are looking beyond the label to the operational reality.
High expectations
There are number of lessons to take away from this. The experience of Tesla shows the risks inherent in the high expectations afforded to this part of the market. Any weakness comes with a savage hit to the share price. However, the strength of Nvidia’s performance shows that the growth of artificial intelligence and chip related industries is real. It is winning a greater share of the overall earnings pie and remains ahead of its competitors.
This argues for selectivity and a note of caution. In some portoflios we have reduced exposure to the market cap weighted indices while retaining core exposure in recognition of the long-term importance of these businesses. These can be complemented by other strategies, such as Equal Weight, Income and more Value managers.
The best of the rest
A second question is where the wider US market will go. It is plausible that market leadership will narrow to the ‘Fab Five’ or whatever new label suits the headline writers. Alternatively, the recent experience with the Magnificent Seven may suggest that the market is paying closer attention to earnings and valuations, and will therefore be more inclusive.
Certainly, valuations are far more comfortable outside the megacaps. The S&P 500 Equal-weighted index, shows a forward price to earnings ratio of 16.6x, compared to 20.2x for the standard S&P 500 index, where the technology giants are far more dominant. It is a similar picture for price to sales (2.33x versus 1.45x), or price to book (2.71x versus 4.04x).
However, margins are still far higher for the largest ten stocks in the S&P index – 20% at the end of 2023, versus 12% for the broader index. The issue is determining the cross-over point, where expectations are too high even for the higher earnings, or are too low for the growth available. Our view is that earnings dispersion is setting an increasingly high hurdle rate for the US tech sector while the broader US market is looking more realistic.
Smaller companies have been a particular laggard, as they have been elsewhere, and have seen some repricing in the recent earnings season. While calling turns in the market is not our approach, these valuation gaps tend to even out over time. Periods of small cap weakness tend to be followed by a period of stronger performance. Equally, smaller companies may be in a better position to benefit from the US’s buoyant domestic economy.
More broadly, there are plenty of other exciting areas in the market: the progress on obesity treatment, the beneficiaries of reshoring, the technology supply chain. Technology is not the only game in town.
We believe there is a growing risk in relying on a handful of index giants to do the heavy lifting on portfolio returns, nor do we want to overlook the other 493 companies in the main index in the largest economy in the world. As we move through 2024 we will continue to be on the lookout for pockets of value across the broader US equity market, potentially focussing in on specific sectors or market cap segments.
Main image: joshua-woroniecki-bRuaLZ302lY-unsplash
