The Magnificent 7[1] could have more to offer, but strong research and a selective approach will be crucial.
After such a strong run in 2023, common sense suggests that tech stocks must be expensive. Granted, they are certainly not bargain-basement stocks, but two interesting points give pause for thought.
Firstly, they are not eye-wateringly expensive. Excluding Tesla, the Magnificent 7 have price/earnings (P/E) ratios[2] in the 20-35 range[3]. This is certainly more expensive than the US market, which has a P/E of 18.7, but less than the US IT sector’s P/E of 38 and well below the US tech P/E of almost 70 seen during the dot com boom.
Secondly, they are only moderately more expensive than they were 10 years ago (cheaper in Amazon’s case, which used to be on 100x earnings) – as is the market as a whole. This implies that stocks have been driven higher by growth in company earnings, not by investors’ hopes.
It also implies that the market’s confidence in the growth of large-cap tech earnings is little different to 10 years ago, and that’s surprising.
It is clear that large-cap tech stocks have grown far more than the market expected 10 years ago. Had the market fully grasped tech’s potential, then the value placed on that by the market should have been much higher.
Is the market still underestimating tech’s potential? For some stocks, we think so.
Monopolies – it’s not all bad
Big tech companies are often natural monopolies because it is difficult for newcomers to challenge their lead in expertise and product delivery.
On the face of it, monopolies are generally a bad thing for investment returns because they tend to stifle innovation, accumulate costs and increase prices. In large-cap tech, however, monopolistic dominance has helped produce multiple quality products, in many cases at low cost to end consumers – such as free internet searching. And because many of these companies can be considered natural monopolies, their ability to grow is likely to remain strong.
Furthermore, the presence of these natural monopolies does not appear to have stunted the prospects for other companies. If we compare individual stock performance to simple average stock performance, we find no significant change across the last 10-15 years. Each year, around 45% of stocks return more than the average.
Will the rest of the market catch up?
Historically, equity markets have risen by roughly 7% between the last Fed interest rate hike and the first rate cut. Some assessments suggest that recent rises in equity markets reflect ‘pricing in’ of anticipated interest rate cuts.
However, around 25% of the total increase in market cap so far this year has come from the Magnificent 7 (despite a 30% fall in Tesla’s stock price). By contrast, non-Magnificent 7 stocks have risen by roughly 6%. Valuations have increased, but not dramatically, so we should avoid jumping to the conclusion that the market is now expensive.
Can the non-Magnificent 7 stocks catch-up? Most market participants appear to expect a benign economic environment in 2024, with moderating inflation, falling interest rates, improving economic activity and only moderate impact from the rate hikes of 2023.
These are not the conditions for a ‘catch-up’ scenario. That would require a much more positive outlook for the economy and/or corporate earnings that are more positively geared to the economy than in the past – neither of which seem likely.
For the avoidance of doubt-avoidance
In The Psychology of Human Misjudgement, Charlie Munger cites 24 sources of misjudgement, the fourth of which is “doubt-avoidance tendency”. This is the desire to eliminate doubt or uncertainty, often by reaching strong judgements quickly or adopting beliefs.
The current situation is uncertain: large-cap tech companies are driving the market higher, but they are also increasing earnings significantly – so perhaps it is justified. The Magnificent 7 appear expensive, but they are not dramatically more expensive now than they were in the past. And in the past they were good value.
Doubt avoidance encourages us to make a quick judgement, but deeper research suggests that this is inappropriate. The Magnificent 7 share a name, but they are different businesses that require individual analysis and investment decisions.
[1] Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla
[2] A price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share (EPS). A high P/E ratio could mean that a company's shares are overvalued or that investors anticipate a high growth rate.
[3] All data in this article sourced from Bloomberg, Macrobond and MSCI as at 26/03/2024
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