When a small clutch of stocks warrants a name, it implies shared characteristics. In the case of the Magnificent 7[1], they are all tech stocks that produced outstanding returns in 2023. But this is by no means the whole story.
In fact, only two of the Magnificent 7 were in the MSCI World’s top 30 performers in 2023[2]. First place went to Coinbase, a crypto exchange, while Rolls-Royce romped in 5th with a 240% return.
The Magnificent 7’s key similarities are actually: they are tech stocks, they performed well and they are extremely large. What is most striking is that such huge companies saw big stock price increases, not the stock price increases alone.
Market performance is generally calculated on a market capitalisation weighted basis, so large market capitalisation stocks tend to count a lot more than smaller ones. This magnifies the importance of stock price returns of large tech stocks.
Tesla, for example, has almost 100x the market capitalisation of Rolls-Royce, so Rolls-Royce’s stock would have to do 100x as well as Tesla’s to have the same influence on the market capitalisation weighted market return.
Aren’t tech stocks a bit expensive?
Turning to valuation, we might expect tech stocks to be extremely expensive at the moment. 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 in the 20-30 range. Secondly, they are only moderately more expensive than they were 10 years ago (cheaper in Amazon’s case), as is the market as a whole.
This implies that stocks have been driven higher by earnings growth. It also implies that the market’s confidence in the growth of large-cap tech earnings is little different to 10 years ago. Given these stocks’ history this might appear surprising.
It is clear in hindsight that the accumulation of economic value by large-cap tech stocks has far exceeded what was expected 10 years ago. Had the market fully grasped tech’s potential, then the multiple-based valuations should have been much higher. It could therefore be considered that the intrinsic value of large-cap tech stocks 10 years ago was actually much higher than the market believed at the time.
Is the market still underestimating tech’s intrinsic value? For some stocks, we think so. Their dominance in what are often natural monopoly markets (where they are protected by high barriers to entry) means they are likely to continue to grow their earnings at a rapid pace.
In an increasingly connected world, larger companies that offer connection-related products and services, such as cloud-based computing or ubiquitous customer access, will tend be in an advantageous position.
Monopolies – it’s not all bad
On the face of it, monopolies are generally a bad thing for investment returns. They tend to defend the status quo, stunt 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.
One might argue that these products were developed primarily when the large tech companies were rather less large, and that there is little reason to believe that ‘this time is different’. But since many of these companies can be considered natural monopolies, their capability to capture economic value is likely to remain strong.
If we compare individual stock performance to simple average stock performance, we find no significant change across the last 10-15 years. Each year, somewhere in the region of 45% of stocks return more than the average. While one might expect the centralisation of economic power to lead to concentration of earnings growth and hence stock returns, that hasn’t happened.
Is small cap cheap?
P/E valuations suggest that larger stocks are expensive relative to their history, while smaller stocks look substantially cheaper relative to theirs. We know that large cap has been outperforming small cap, so this isn’t a surprise. But could it also reflect a recognition that larger companies, particularly tech companies, are seeing increasing returns to scale and that smaller companies find competition increasingly tough?
The objective of an active investor is to achieve investment returns that are superior to the risk taken (however defined). If we assume that stock prices reflect the average insight of investors, then to be successful an investor needs to identify stocks where they have superior insight to the average. That is to say, invest in companies whose stock prices incorrectly reflect the likely economic value of their future activities.
If we compare the market cap weighted MSCI ACWI index P/E to the equally weighted index P/E, we find the market cap weighted P/E is 17.6x and the equally weighted P/E is 13.9x. This suggests that larger stocks are more expensive, but does that accurately reflect the future economic value creation or ‘capture’ of these companies? Does it underestimate the value capture, as the market clearly did in the past?
Today, large tech companies appear expensive relative to their historic average, but no more so than previously. Meanwhile, the outlook for value creation by them appears undiminished, and perhaps even stronger. Significant underexposure to these companies seems inappropriate, and concluding that large-cap tech stocks are ‘about to turn’ is probably unwise.
Will the rest of the market catch up?
Historically, there has been a roughly 7% rise in equity markets 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.
The MSCI World is already up 12% since the last rate hike and developed equity markets have risen by approximately 8% year-to-date. Meanwhile, earnings estimates have risen by a little over 3% year to date, meaning that the market has become more expensive.
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. We should avoid jumping to the conclusion that the market is now expensive.
But will the non-Magnificent 7 stocks catch-up? Asking this question implies that these stocks are a homogeneous group, which is true, up to a point. That point is the economic sensitivity of their earnings compared to the expected economic sensitivity of their earnings and the economic outlook compared to the expected economic outlook.
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 economic outlook 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 his 1995 Harvard speech, The Psychology of Human Misjudgement, Charlie Munger cited 24 sources of misjudgement, the fourth of which is “doubt-avoidance tendency”. This is the very human desire to eliminate doubt or uncertainty, often by reaching strong judgements quickly or adopting ‘belief’ positions.
Unfortunately, investment is inherently uncertain, making unwary investors highly prone to doubt avoidance. And 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 stocks 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 on the outcome of the Magnificent 7 relative to the market. 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.
Two earn their crust from advertising, one from car manufacture, one from device manufacture, one from semiconductors and three from cloud-based services (while also having significant non-cloud businesses). Their year-to-date performance reflects their differences, with Tesla down 30%, Nvidia up 90% and Meta up 40%.
Our approach is to embrace doubt and uncertainty, but mitigate investment performance risk as necessary. This may mean, among other things, reducing large-cap tech exposure or being highly selective. One thing we will not do is rush to judgement or cleave to unexamined investment beliefs in our search for higher-quality companies trading prices below their intrinsic value.
[1] Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla
[2] All data in this article sourced from Bloomberg, Macrobond and MSCI as at 26/03/2024
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