Magnificent who? These are the mega-cap US tech companies, not the star-filled 1960’s Western starring Yul Brynner, Steve McQueen and Charles Bronson, among others.
The modern-day Magnificent Seven are Apple, Microsoft, Alphabet (Google to you and me), Amazon, Nvidia, Meta (Facebook to you and me) and Tesla. These seven companies have been dominating both US and global equity indices. Is their inexorable rise sustainable?
Firstly, a great deal of thanks to our friends at Stewart Investors who highlighted to us what the concentrated nature of S&P 500 has meant for the drivers of performance during 2023.
With the Magnificent Seven dominating the top of the performance tables, from 1 January up to the end of November 2023, a staggering 71% of the performance return of the S&P 500 was driven by these seven companies alone, who accounted for just 29% of the market cap of the S&P 500.
What was even more staggering, is the share price strength of just these seven companies accounted for almost half (49%) of all the returns generated from global equity markets (measured by MSCI All Countries World Index) over the same period.
7 companies that can justify higher than average valuations
This is not to say that these seven are not exceptional companies. They are highly cash generative businesses with great earnings that can justify higher than average valuations. For example, Microsoft needs to generate just $3 of revenue to earn $1 of free cash flow.
The explosion of interest around artificial intelligence (AI) last year increased both the share prices of these companies, but also investor expectations.
Having a high valuation does not mean this isn’t justified if you can successfully grow your earnings quicker than others. However, stock market history is littered with examples of groups of stocks being bid up to ever higher valuations before falling under the weight of their own lofty valuations.
Examples include the Nifty Fifty of the 1960s and 70s, Japanese equities in the late 1980s, and the dot-com stocks of the late 1990s. Trends can last for a very long time, but exceptionalism is rarely permanent.
There are a couple of implications to this, predominantly about being aware of what you own.
The first is the share prices moves of these seven companies have typically given passive, index-tracking funds an advantage during recent times as many active managers are wary of the underlying valuations being applied and so typically have a lower overall weighting in their funds than the index.
In a year, such as 2023, when positive returns have been so narrowly focused across such a small number of individual companies, not owning the market weight, and then failing to increase it in line with their share price growth has been a major performance headwind.
This is particularly the case in many funds with a responsible, sustainable or impact focus, as many of these funds will screen out the Magnificent Seven as part of their investment process (often for governance reasons).
Second, for passive investors, the awareness that concentration risk is increasing.
A decade ago, a passive investor in US equities (measured by MSCI US Index) would have seen just under 20% of their tracker invested in the combined weight of the information technology sector and those Magnificent Seven stocks that sit outside the IT sector, with the Magnificent 7 accounting for just about 7%.
Jump forward a decade and the same combined group account for over 40% of the index, with the Magnificent Seven now accounting for over 25% of the same index.
Source: Fidelity International Limited, data as at 26 May 2023
It is not only concentration risk in the form of individual company risk that there needs to be an awareness of. US companies dominate global equity indices in ever-growing proportions. A decade ago, this time using the FTSE World as an index, US equities accounted for just under half the global equity market. Today, that is over 65% as a decade’s worth of US equity market dominance takes its effect. As a corollary of this, the global equity index tracker has become dominated by the outlook for the US dollar too.
So what? I hear you say, and you could well be right. The US equity market has been in a period of dominance since the global financial crisis and the US dollar has been in ascendancy too, particularly against poor old sterling.
These are long-term trends that we’ve all become used to, but data from Schroders suggests the more concentrated an index becomes, the better served you are for future returns by diversifying away some of that risk.
That stands to reason. In our Core portfolios, we maintain a balance of funds with the aim of doing just that, diversifying across countries, sectors, investment styles and company size. In our passive portfolios, there’s less wriggle room, but here we have steadily been reducing exposure to the largest US companies and increased exposure to the broader US equity market as well as increased the country mix.