Fixed Income EnvironmentOctober 5, 2023
The Spirit Of BonnievaleOctober 6, 2023
An Article by Ian Kilbride.
What do Steve McQueen, Yul Brynner, Denzel Washington, Chris Pratt, Tesla and Invidia all have in common? Answer: they’ve starred in the Magnificent Seven. For me, the original 1960 movie beats the 2016 version hands down, but what of this year’s septet?
The new ‘Magnificent Seven’ is the name given to the seven mega cap company stocks that have collectively come to dominate the S&P, accounting for some 28% of the index and for almost 65% of its returns year to date. These Leviathans of the US stock market have replaced the collective FAANGS acronym and are constituted of: Apple, Microsoft, Amazon, Google, Nvidia, Tesla and Meta (Facebook), with a collective market capitalisation amounting to $13 trillion. To place this in perspective, the US gross domestic product is just a little over $23 trillion. Stated differently, the combined value of these super heavyweight stocks is more than 18 times the entire South African economy. By mid-year, these power houses had on average delivered astonishing returns of 107% for the year.
But how are they in fact magnificent and why are they the dominant players on the S&P? Most are well-known household names, but Nvidia is less so. The company’s share price is being driven by the excitement and potential of Artificial Intelligence (AI) in which it holds about 90% of AI driven graphics processing units in high-end computer data centres. The other six continue to enjoy huge market dominance and have demonstrated a unique ability to innovate in order to remain ahead of the competition. Microsoft is still the dominant operating system for personal computers and its Azure platform is No.2 in cloud infrastructure service sales. Alphabet’s Google enjoys 90% of worldwide monthly searches and YouTube is the No.2 visited social site globally. In the case of Meta, despite its recent challenges, it continues to attract 3,8 billion monthly active users. The now profitable Amazon accounts for 40% of all US online retail sales and is No.1 in cloud infrastructure service sales.
While recent growth and returns for these corporate giants has been quite magnificent, and investing in them may seem like the proverbial ‘slam dunk’, life for investors and asset managers in particular is never that straight forward.
Firstly, such remarkable growth has made these stocks expensive to invest in by any measure. The average price to earnings ratio for the Magnificent Seven is 112 times. In other words, buying these stocks at these levels translates into paying now for over a century’s future earnings. This is in contrast with the historical average of 15-18.
Amazon, with a PE of 312 leads the stratospheric valuations, with Nvidia following at 250 and Tesla at 86. While not doubting the brilliance of these companies and their future potential earnings, it is hard to justify these price earnings multiples on any reasonable, sober and balanced measure. A deeper dive into Tesla for example, raises concerns about the sustainability of its leadership and dominance in the electric vehicle (EV) market. This is particularly the case in light of the major manufacturers producing significantly more hybrids and gearing up for the massive global switch from internal combustion to battery powered vehicles. Notably too, China is now the world’s biggest EV producer and manufacturer.
Moreover, a number of the businesses are cyclical and sensitive to broader economic patterns, particularly a downturn in consumer and advertising spend. Here one thinks of Meta in particular which generates 98% of its revenue from advertising. Alphabet is similarly advertising dependent. While Apple continues to innovate and retain brand appeal and its capital return programme has been remarkably successful, it faces headwinds in China and from equally innovative competitors, particularly on price.
But for asset managers and fund investors favouring a more balanced, long term investment philosophy, style and approach, there is a broader and deeper concern around the Magnificent Seven which is the over-concentration of the indexes. Stripping out the septet, the S&P 500 has struggled to return over 1% for the year. The current concentration of the top ten stocks on the S&P 500 is now some 30%, in contrast to around 20% for the past 35 years. Indeed, today’s concentration is even higher than before the dot com bubble burst. Historically, such high concentrations have broken and produced a significant a rerating across the major indexes. It remains to be seen whether this concentration peak will be any different.