The ‘Magnificent Seven’

In his latest memo ‘On Bubble Watch’, renowned investor Howard Marks discussed the phenomenon known as the ‘Magnificent Seven’ (hereafter M7) – Apple, Microsoft, Amazon, Alphabet (Google), Meta (Facebook), Nvidia, and Tesla – the popular US tech giants which have driven much of the S&P500’s performance in recent years. It’s well worth the read. I’ll highlight some of his comments below:

“My early brush with a genuine bubble caused me to formulate some guiding principles that carried me through the next 50-odd years:

It’s not what you buy, it’s what you pay that counts.

Good investing doesn’t come from buying good things, but from buying things well.

There’s no asset so good that it can’t become overpriced and thus dangerous, and there are few assets so bad that they can’t get cheap enough to be a bargain.”

“When something is on the pedestal of popularity, the risk of a decline is high.”

In the last 2 years, the average return of the M7 was 269% vs the S&P500’s 58%. Nvidia (+820%) skews that number somewhat: The median M7 stock ‘only’ returned 161%, still multiples ahead of the S&P500. It’s not unusual to find a group of outliers (typically identified after-the-fact), but what is unusual is that these 7 outliers are the 7 biggest listed companies in the world (by market capitalization), at the time of writing. When the outliers make up a third of the most popular index in the world, they cease to be outliers in the normal sense of the word.

These are undoubtedly some of the best businesses in the world, but the question is: Should we expect them to persistently outperform everything else? Should we be chasing them because of their superior returns? What about risk? And what do these stocks look like at an individual level?

As you consider the following data, keep Howard Marks’ comments above in mind.

At an aggregate level, the median price/earnings ratio (PE) of the M7 is 37x, while the median PE of the rest of the S&P500 is 22x. The long-term average PE of the S&P500 has been around 19x. The M7 trades at a premium of nearly 70% to the rest of the index, and nearly double the S&P500 long-term average. Individually, the M7 PE ratios are: Apple – 37x, Microsoft – 35x, Amazon – 45x, Alphabet – 25x, Meta – 27x, Nvidia – 53x, Tesla – 192x.

It’s worth noting that Nvidia – the star of the M7 – currently has net profit margins of ~55%, owing to insatiable demand for its powerful AI chips. This is double their long-term average, and double their peers. Margins like this attract competition, which eventually leads to lower margins. That’s a significant long-term risk that the market doesn’t seem to be concerned about at present.

The following graphs show how the total return (green line) of each of these stocks has developed relative to its sustainable return (blue line), along with a projected range (dotted lines) for future sustainable return based on a range of analyst estimates (high/consensus/low). The relationship between these 2 lines is that the sustainable return ultimately determines the path which total return follows. That doesn’t mean that total return can’t diverge dramatically from sustainable return for an extended period. Rather, extreme divergences are the hallmark of irrational/bubble-like behavior.

Apple:

Apple is well-ahead of its sustainable return, though not in classic bubble territory. Growth expectations are lower than the peer group, which suggests that Apple is priced for disappointing long-term returns.

Microsoft:

Microsoft is also well-ahead of its sustainable return, though growth is expected to be strong in coming years. Relative to consensus growth expectations, Microsoft is more reasonably priced than Apple.

Amazon:

Amazon is reasonably priced, though growth expectations have moderated relative to the past decade.

Alphabet (Google):

Alphabet is trading in-line with its sustainable return, with strong growth prospects. Google is the largest holding in most of our portfolios.

Meta (Facebook):

Meta is a very similar story to Alphabet. This is also one of our largest holdings.

Nvidia:

Nvidia has experienced dramatic growth in the last 2 years, but it’s total return has far outstripped its sustainable return. While still falling short of classic bubble extremes, the divergence between total return and sustainable return is very high and suggests disappointing future returns under all but the most optimistic scenarios.

Tesla:

Tesla exhibited typical bubble-like behavior between 2020 and 2022. We’ve seen a resurgence of this in 2024.

 

The ‘Magnificent Seven’ have dominated the investment landscape in recent years. They have an air of invincibility about them, and there’s a prevailing sense that their prices can only ever go up. But this isn’t the case: As recently as 2022, when the S&P500 declined 18%, the median M7 stock lost 50%. Regardless of how good the underlying business is, if the stock price becomes detached from sustainable return, it creates a very real risk of loss. This isn’t the case for every M7 constituent though. Rather than considering the group as a whole, it makes sense to assess the merits of each stock individually, as we do with the rest of our investible universe. This is why we hold large positions in Alphabet and Meta, but not the rest.