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Tired of raids by local bandits, the farmers of a poor Mexican village hire a group of gunslingers from across the US border to protect them. So goes the plot of the 1960 movie classic, The Magnificent Seven.
Last year, the same epithet was attributed to the seven stocks that produced most of the growth in global equity markets. They, too, offered protection — to savers seeing their wealth ravaged by inflation. But are they up to the job longer term? And how might this story end?
Investors love catchphrases for stocks and markets on fire. Around the time The Magnificent Seven was pulling in cinema crowds, markets were being led by what became known as the “Nifty Fifty”. Many of these were growth stocks, including the hot technology businesses of the day — Xerox, IBM and Texas Instruments — while others belonged to consumer companies such as Coca-Cola and Procter & Gamble.
Investors saw the group as an easy and reliable list of “going-up stocks”. They were so good that “nothing bad could happen to them”. And that meant no price was considered too high to pay for them. By the early 1970s, the average price/earnings ratio multiple had reached 50x — not-so-nifty!
When the oil crisis came along and markets tumbled, this group fell a lot more than most — over-loved, overpriced and open to profit-taking. That said, despite one or two of the Nifty Fifty stocks failing over the past half-century, buying and holding this set would probably have worked rather well — especially if one had bought in at any time other than the valuation bubble in 1971-72. The bulk of the holdings have compounded high returns to date. The lesson is that valuations matter.
In 2001, the acronym Brics was coined for the emerging markets seen to have the best growth prospects — Brazil, Russia, India and China. Backing these economies has been less successful for investors. In stock market terms, only India has performed particularly well all the way through.
China had a good noughties, but equity returns have been poor for the past five years — despite the economy now being the second largest in the world. Terrible returns from Russian equities underline the political risk that investing in some emerging markets can entail.
In short, then, these labels are no guarantee of investment success. So what about the Magnificent Seven? Looking ahead, they can be split into two groups — those that most obviously benefit from artificial intelligence and those that do not.
The AI beneficiaries offer either infrastructure or AI-enhanced services (and in Microsoft’s case, both). On the infrastructure side, AI will require powerful chips and enormous storage. Nvidia leads in the manufacture of advanced semiconductors; Microsoft and Amazon provide cloud-hosting.
In terms of AI services, Meta and Alphabet both offer large language models — Meta’s LlaMA and Alphabet’s PaLM. The latter is used to power Google Bard, an experimental AI chatbot that can draft article outlines, summarise text and translate.
Meanwhile, Microsoft is increasingly integrating AI into its core programs, such as Word, Outlook and PowerPoint, to enhance productivity, and using it to enhance its search engine, Bing, which until now has been an also-ran alongside Google.
If these services prove as popular as hoped, a range of second-tier companies could also grow rapidly. They include cyber security providers, such as Palo Alto Networks and CrowdStrike, and semiconductor designers and testers, such as Synopsys and Advantest. Despite many of these stocks trading on high multiples of current sales (and higher multiples of earnings), I own small positions in most of them.
The odd ones out are Apple and Tesla. Apple is not currently seen as a major beneficiary of the AI boom. If AI allows non-IT professionals to enhance and tailor applications without having to hire a coder — as Windows did when it first emerged — we might see a rise in the value of a range of consumer applications, such as those in Apple’s App Store.
As an early example, if you are impressed by the new versions of the Bing search engine, you might imagine how AI could enhance other apps you use. But will that make a big difference to Apple’s revenue? I could be wrong, but I doubt it.
Tesla has little in common with the others. It makes electric cars and faces increasing price competition from other makers, especially the Chinese.
The Magnificent Seven’s share prices have already risen sharply, largely on hopes for AI. In the coming fortnight we will have earnings updates for all but Nvidia. Those results will be judged in two ways. Is the revenue growth showing signs of a multiyear boost from AI? Or, if not, is the chief executive’s outlook statement still confident that such a boost is on its way?
The price/earnings (and often price/sales) ratios of these stocks can look high — but not as stretched as those of Big Technology shares in 2000. Indeed, a few years of double-digit sales growth could easily justify current valuations for those who capture key roles in this new market.
Meanwhile, the rest of global equities have malingered over the past year and probably now offer better value for money for investors, especially if the threat of inflation is moderating and economies are recovering.
The winners in The Magnificent Seven movie were the farmers, who saw the bandits routed. They got good value for a while, but eventually concluded it was time to move on. Investors may feel the same.
For those who invested earlier in the Magnificent Seven, it seems prudent to take some profits and reallocate to other parts of the world of equities on much lower valuations. I do not believe it is time to sell out of this theme. AI will improve productivity across a large range of industries. While the spotlight is currently on the AI enablers there will be a lot of other businesses that will benefit from its effects. This is a good year to seek out those overlooked opportunities.
Simon Edelsten is a former fund manager
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