Since July was so hot in most parts of the country and everyone, including myself, was just trying to stay cool, I decided to combine the July and August commentary into one "Summer" edition.
Early in my career, I worked as an equity analyst for a small mutual fund company, and one of my sector responsibilities was Technology. With this background, I have closely followed the dominant performance of the so-called "Magnificent Seven" stocks and their increasing dominance of market-cap-weighted broad stock indices such as the S&P 500. Over the last several years, many of our clients have participated in the ownership of several of the "Magnificent Seven" stocks that were bought during rare periods of weakness. But we have been careful not to get caught up in the "buy at any price" momentum psychology that has permeated markets, underpinned by the excitement surrounding the rapid development of Artificial Intelligence (AI).
Using Microsoft's AI agent, CoPilot, we see that "Magnificent Seven" stocks recently had a combined market capitalization of $18.6 trillion and comprised over 35% of the S&P 500's total market capitalization. By comparison, across all our managed accounts, the "Magnificent Seven" represented roughly 9% of our equity allocation. We have been, and continue to be, purposely underweight these mega-cap technology companies, not because we question their dominance and fundamentals, but simply because of the assumptions that the market incorporates into their stock prices, and by extension, their valuation.
These market assumptions appear to be ignoring the risk, which we see as moderate to high, that GPU (Graphic Processing Unit) silicon chip server data centers used to power AI
will end up overbuilt over the next 3-5 years, and/or the expansion will be constrained by the availability of electric power. Further out, there is a very real risk that Quantum computing will partially displace the current GPU compute power that is advancing AI capabilities at scale. When the market is forced to confront these risks to the current AI paradigm, the very lofty growth forecasts driving the "Magnificent Seven's" spectacular valuation would be rerated, likely resulting in a painful valuation adjustment. For investors with a market weighting or higher exposure to these companies, such an adjustment could result in a material drawdown in the value of their portfolio.
For this summer commentary, I will primarily use graphs to provide a montage of visual representations and brief commentary, illustrating why we choose to be very cautious when investing in the "Magnificent Seven" companies.
Anyone who has been paying attention to the financial media and pundits over the last five or more years would have found it difficult to avoid comparisons between today's Mega Cap Tech-dominated S&P 500 and the same index during the latter years of the 1990s. During what is not called the Dot.com bubble, large-cap growth and small, speculative internet companies drove market returns to what turned out to be unsustainable levels. Many of these comparisons are spurious at best because what is being measured cannot be compared without significant adjustments for composition changes to indices, profit market differences, and the difference in the interest rate environment. But the chart above is more relevant because Enterprise Value and Economic Profit are two measures that are not as impacted by accounting methods that change over time or index-related differences, such as sector weighting changes, as shown below:
We also know that the interest rate environment can have a mathematical impact on market multiples, with low rates resulting in higher price-to-earnings ratios and higher rates resulting in lower price-to-earnings multiples. Thus, comparing stock price-driven multiples over time is not a particularly useful exercise, but using valuation methods focused on enterprise value is more comparable over time. We will always believe that valuation will matter over time, especially during market periods when we are told it is different this time.
As predominantly bottom-up investors, we must look through broad market measures that can mask areas where value is compelling. By almost all comparative measures, the market-cap-weighted indices, such as the S&P 500, appear to be fully valued at best, or vastly overvalued at worst. However, when one adjusts for the richly valued large and mega-cap growth companies that dominate these market-cap-weighted indices, a different picture emerges. See the illustration below of the equal-weighted S&P 500:
The above illustration shows that, on average and on a non-market cap-weighted basis, the 500 companies of the S&P 500 are trading at earnings multiples just slightly above the five-year average of 16.3 times. Thus, in a market dominated by big, exciting secular themes, such as artificial intelligence (AI), a small number of large and richly valued companies grow within the market, fueled by a thematic excitement that drives price momentum. These types of markets are very alluring to both traders and FOMO investors. The consequences of such a large, momentum-driven broad market are that the crowd overlooks the vast majority of other stocks, and the valuation differential between a small number of huge, thematic-driven momentum stocks and the average of the rest of the market grows. Historically, these types of markets emerge during inflection points in technology, earning those market periods nicknames. In the late 1960s and early 1970s, the market was driven by the "Nifty 50" stocks, and in the late 1990s, it was characterized by the "Tech Revolution" or "New Economy" market. The three common elements of these market periods are an "it's different this time" attitude, infinite growth forecasts, and an abrupt, unexpected ending.
Arguably, the Nifty 50 period in the markets may be the best comparison to the recent market period due to the similarity in significant and mega-cap stock dominance. There is limited data available to compare large- and small-cap valuations during the Nifty 50 period. Still, Microsoft Copilot was able to compile data on the Nifty 50 forward P/E valuation versus the same for the equal-weighted S&P 500, and this is illustrated in table form below:
There are lessons to take from the previous "named" market periods. These lessons are not a precise roadmap to managing risk, but they do inform us about how to identify warning signs. The risks associated with the Magnificent 7 (AI Boom) market are worth paying attention to. However, as with previous inflection point markets, there are very real investment opportunities being created, and we are not ignoring them.
Our security selection process incorporates a rational, forward-looking, and valuation-sensitive approach. Given that process, coupled with our preference for growth companies, drives us to look for less obvious beneficiaries of the current inflection point secular trends. We start with an understanding of business fundamentals, assumptions built into current prices, and forward-looking value drivers over a long-term time horizon. This process is the opposite of a momentum and passive buy-at-any-price thematic investing environment that prevails in markets like those we see today.
In general, over the last several years, we have found the majority of our value opportunities beneath the Mega Cap cohort of stocks. Nowhere is the valuation disparity more apparent than in the small-cap space. See this disparity illustrated below:
The small-cap valuation premium relative to large-cap stocks recently peaked in 2011, and the small-cap relative valuation turned negative in 2018. Is the duration of the current large-cap valuation premium period an unprecedented phenomenon? Not really, but its duration is slightly longer than average. See below:
Our view of the stock market is broader than the S&P 500, encompassing not only U.S. companies but also international markets. We differentiate our process by looking beneath the surface of major indices, such as the S&P 500, Nasdaq 100, or Dow Jones Industrial Average, for less popular but equally or more compelling investment opportunities nonetheless. Howard Marks, whom I quote quite regularly, and Joel Greenblatt, the esteemed investor and professor who wrote the famous stock investing book Magic Formula, each have quotes that fit very well with this month's commentary, see below:
"The process of intelligently building a portfolio consists of identifying undervalued securities and avoiding overvalued ones. This can't be done by simply buying the index." Howard Marks
"The S&P 500 is market-cap weighted, which means the most expensive stocks get the biggest slice. That's not where you find value." Joel Greenblatt
Active management and individual security selection are very time-consuming and challenging endeavors, which is why most of our industry has shifted to some version of passive model-based portfolios. These portfolios can be easily managed at scale and eliminate the work involved in security selection. We embrace this work and continue to adapt our process to changes in market structure and the continuous innovation in the financial industry, staying true to our discipline while continuously seeking ways to be more efficient and effective.
