Are expectations for the Magnificent Seven too high?

As we’ve seen, the market’s current obsession is with artificial intelligence (or AI) and the ‘Magnificent Seven’: Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla. As a group, they represented 70% of the S&P 500’S 2023 return. Standout winner Nvidia closed the year up 239%, while Apple, the relative laggard, returned 48%¹. Today, those seven companies  command as much market value as the “Foreign Five”, the largest developed stockmarkets outside the US by market value.

While these tech giants have dominated the headlines in recent years, this phenomenon is nothing new. Before our recent market darlings, we had the FANG quartet (Facebook, Amazon, Netflix, and Google). Go back even further and you’ll find the BUNCH companies—Burroughs, Univac, NCR, Control Data and Honeywell—the forgotten darlings of the mainframe computing era. After soaring to dizzying heights for many years, they too eventually came back down to earth.

So, what lessons can we learn from history and are there any markers that can help navigate the current zeitgeist?

Valuations vs expectations

The key is in valuations and expectations. Stocks go up when results are better than investors anticipated. So, you make money by owning businesses as their outlook brightens. Sometimes that means buying the business when others think the outlook is dim. The higher the valuation, the higher the expectations, and the greater the scope for potential disappointment.

Today, the valuations of some of the mega-cap giants are incredibly high. That sets a high bar. For some of them, expectations are so high that they must deliver blindingly fast growth simply to justify their current prices.

Take Microsoft, for example. While Microsoft may make $101bn in operating profit, the market then expects it to grow at 10-15% a year – so it needs to grow profits by $10-15 billion a year, compounded over time. That’s like growing a brand new Coca Cola in 2024, and then another in 2025, and so on.

Even the growth expectations for Nvidia are astounding. In 2023, as a whole, Nvidia presented revenues of almost $61 billion, up 126% from a year ago. Having beat market expectations in the fourth quarter, Wall Street expects Nvidia to grow by 35% per annum for at least half a decade. Even for the best companies in the world, such growth rates are really hard to sustain.

The trouble is, that growth potential is clear to everybody. So those expectations are already reflected in the stock’s price. Today that price is high. Nvidia trades at 20 times estimates for next year’s sales. That’s 20 times the top line, before any expenses. It’s not impossible for a business to deliver the sort of growth now expected of Nvidia. It’s just exceedingly rare.

The sombering reality

We decided to see how rare. Since 1990, just 230 stocks in the FTSE World Index have ever sustained 30% revenue growth for more than five years. That’s just 7% of the 3,400 relevant stocks in the Index. The feat is even rarer for large companies. Just 45 businesses have ever delivered that kind of growth after cracking the top 200 of the Index.

The hit rate is higher for huge expensive companies, suggesting that markets do have some signal. 23% of huge companies trading for more than 10 times sales have gone on to sustain 30% revenue growth. But that is less encouraging than it first appears. The flip side is that three-quarters of the time, it doesn’t play out. Three-quarters of the time, huge expensive companies don’t deliver the blazing growth now expected of Nvidia.

Valuations reflect expectations and in the investing world, high expectations can often lead to disappointment. If we take a long view of history, that’s often the patten and valuations are often highest just after a company has burned brightest. Now that is a recipe for disappointment and poor returns.

Beyond the magnificent seven

Fortunately, there is an alternative to chasing the leading lights. Look beyond the Magnificent Seven, and there are thousands of companies out there—many of which will have brighter futures than the market now expects. In 2023 alone, many good-sized companies returned more than Apple’s 48% return.

But the spotlight doesn’t shine on these businesses. It’s hard to tame the fear of missing out, especially when the companies leading the way continue to beat expectations quarter after quarter. But rather than crowding into giant companies that must continue to shine brightly just to hold their prices, we much prefer to invest in companies that trade at discounted valuations, and are trying to clear a lower bar. It is more rewarding to be there before their time to shine.

The important thing is that with such an uncertain backdrop, now is a critical time for investors to be open-minded and adaptive—as continuing to stick with past winners is no guarantee of success, especially when the valuations trend of the Magnificent Seven begin to strongly resemble the Nifty Fifty of the 1970s.

¹ Source: https://www.investors.com/news/sp-500-magnificent-seven-stocks-had-a-huge-2023-all-are-near-buy-points-heading-into-2024/

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