Will the magnificent seven ride again?

It was almost impossible to read any equity market commentary last year without some reference to the ‘magnificent seven’ basket of stocks.

The term refers to the seven largest companies in the US by market capitalisation, namely Google parent company Alphabet, Amazon, Apple, Meta (formerly Facebook), Microsoft, Nvidia and Tesla.

Over 2023 as a whole, the average total return for these stocks was an amazing 122% - for context, the broader S&P 500 index was up 26%.¹

It's therefore little surprise that these names have garnered such attention.

The impressive nature of these returns is magnified when we consider the size of these companies. When presented with a list of stocks that soared between 49% and 239% in a year, you could be forgiven for assuming these were success stories from the world of small-cap investing.

This couldn’t be further from the truth: the seven names collectively represent roughly $12 trillion in market cap.

As a group, these seven stocks accounted for 60% of the S&P 500’s total market gain last year, as shown in the chart below:

This is despite the broad-based market rally we saw in Q4 last year; even more strikingly, the proportion stood at over 85% of the year-to-date market returns at the end of September.

Concentration risk?

This extreme outperformance led to a debate around index concentration. These companies became so large that the Nasdaq 100 index even had to implement a ‘special rebalance’ to ensure that funds tracking the index did not breach industry-wide concentration limits set by regulators.

But why did these stocks perform so well last year?

First, it’s easy to forget how poorly they performed in 2022. Given their longer duration growth characteristics, their share prices suffered significantly in the 2022 bear market as the US Federal Reserve ramped up interest rates.

We can see in the chart below that the seven stocks experienced a drawdown of more than -40% in 2022:

Their subsequent strong performance in 2023 has only just recovered these losses. In other words: they were coming off a low base.

Second, stocks offering structural earnings growth last year were hard to come by. The consensus among analysts is that the magnificent seven will report earnings growth of 31.4%² in 2023.

This is in stark contrast to the collective remainder of the index constituents (i.e. the rest of the S&P 500), which are forecast to record -5.8%³ growth.

Also, although not quite as extreme, the big seven’s earnings growth is still expected to be more than double the other constituents in 2024 at 18.2% vs 8.6%⁴ for the rest of the herd. 

These are some of the most profitable and cash-generative businesses in the world. With little debt, they are largely sheltered from interest rate hikes. We think they should face less disruptive competition from funding-starved smaller companies, adding to the resilience of their earnings in an environment with a higher cost of capital.

In short, a scarcity premium has been attached to these mega cap names.

Can the run continue?

Given their ability to significantly influence the index, investors are naturally focused on what 2024 holds for this exclusive group. Will they continue to behave as a pack, could a new group form – or will the 493 laggards catch up?

The extent of the correlation between these stocks last year certainly surprised us. We see them as very different businesses: Tesla is an electric vehicle manufacturer, Amazon is an online e-commerce platform and cloud computing provider, Apple is a luxury electronics manufacturer, and Nvidia is a semiconductor design company. Under the ‘tech’ veneer, these are very different products and operating models.

We therefore see their outlook as mixed. We believe that this correlation will break down, with stock price movements driven more by each firm’s idiosyncratic fundamentals. Our reasoning is explained in part by the following chart, which dissects the total return of each stock in 2023:

As shown, the substantial returns were driven by varying amounts of valuation reratings and earnings revisions. We see those names whose returns were purely driven by valuation re-ratings, most notably Apple and Tesla, as most at risk of underperformance in 2024 given their lack of support from upward earnings revisions.

It is also very interesting to see how, despite a monumental 239% return last year, Nvidia became cheaper on a forward price-to-earnings basis as 2024 earnings were revised up nearly 270%. 

We see technology as the great enabler of the 21^st century. Much like automation and electrification, there are certain innovations that transcend traditional industries and shouldn’t be thought of as sectors in themselves.

We believe that businesses that embrace these innovations, regardless of their industry, have the greatest chance of success. While this is a unifying feature, there are often many other distinct factors that can influence their long-term returns.

We therefore look to 2024 to see how fundamentals (and/or potential AI-driven innovations) impact those businesses that have leveraged technology to propel themselves ahead of their peers, but now need to make sure that others aren’t able to catch up.

1. Source: Bloomberg as at 19 January 2024

2. Source: Barclays as at 19 January 2024

3. Source: Barclays as at 19 January 2024

4. Source: Barclays as at 19 January 2024