The Perspective Blog
Return of the Mega-Caps
Return of the Mega-Caps
2023 has been an anomalous year in financial markets. If you’ve been following the headlines, the main story you’ve probably seen is that market performance has been strong. For the first six months of this year (to June30th), the S&P 500 has increased by +15.5%, in US dollar terms.
But there’s another story hiding underneath the surface: returns in the US market have been almost entirely driven by just seven of the largest mega-cap technology companies: Tesla, Amazon, Microsoft, Apple, NVIDIA, Alphabet (Google), and Meta (Facebook) – which now make up a staggering 28% of the overall index. In the first six months of the year, an equal-weighted portfolio of these seven stocks would have returned +89.0% in US dollar terms. The rest of the market has not performed so spectacularly.
To show just how much these seven stocks have dominated, the chart below (prepared by S&P Global) shows the total return of the S&P 500 to May 16th (+7.0%) in blue, and the total return of the same index, excluding those seven mega-cap technology companies(-0.8%) in orange. To mid-May of this year, if you were to strip out just those seven companies from the S&P 500,the overall index performance was slightly negative.
And it’s not just US stocks that have languished. Market returns outside the US have also not kept up with the big seven stocks, as measured by the S&P/TSX (+5.7%) and MSCI EAFE (+9.5%)year to date returns as of June 30, 2023. Taken together, the vast majority of global stocks have faced serious headwinds as central banks have continued to hike interest rates in their efforts to fight inflation. The Bank of Canada has increased its overnight policy rate from 0.25% to 4.75% in just 18 months, and the Federal Reserve has increased the Federal Funds Rate from 0.0% to 5.0%over the same period.
So, what might explain the incredible performance of these seven mega-cap technology companies in the first half of2023? After all, technology companies tend to be more sensitive to changes in interest rates than the average company, not less – as they are not expected to make the majority of their cashflows until much further into the future.
One factor driving the performance of these seven stocks is a simple reversion to the previous sky-high valuations they traded at before the 2022 downturn in markets. Although their six-month performance numbers look incredibly strong, that comes on the heels of a dismal 2022 for most of these companies. An equal-weighted portfolio of these seven stocks would have lost -46.2% of its value in 2022. Even after their strong recovery in the first six months of this year, this hypothetical equal-weighted portfolio would still not have recovered to its previous all-time high after the roller coaster ride of the last 18 months.
A second factor that may be driving strong returns for these stocks is elevated expectations, largely driven by recent developments in the artificial intelligence space. Large technology companies tend to have a competitive advantage in artificial intelligence, due to their access to libraries of user-generated data and ability to make large capital investments.
But, as you can see from the P/E (Price/Earnings) ratios in the rightmost column of the above table, at their current prices, these companies all trade at very expensive valuations. These seven companies now trade at an average P/E ratio of 44.1x. This compares to the other 493 stocks in the S&P 500 that on average trade at a P/E ratio of 15.0x. No one would argue that any of the above seven companies are not incredible businesses, but the question remains -- are they such incredible businesses that their stock prices should be nearly 3xmore expensive than the typical S&P 500 company?
To illustrate the stratospheric valuations that these companies now trade at, let’s focus on NVIDIA Corporation. Aswath Damodaran, the NYU Stern professor best known for his books on stock valuation, owns a position in NVIDIA. He points out that NVIDIA is an incredible business – it has maintained strong earnings growth during difficult periods and has also consistently achieved above-average profitability. However, when he performs a breakeven analysis for the stock at its current price of approximately $450/share, he finds that the company would need to maintain “a daunting combination of extraordinary revenue growth and super-normal margins” and would need the following set of circumstances to all come true:
- The demand for chips in artificial intelligence would need to grow by a factor of 10x or more in the next ten years
- Chip demands in the auto sector would also need to increase substantially
- NVIDIA would need to maintain a very high total market share in both of those segments
- NVIDIA’s operating margins would need to increase from 40% to 50%, in an industry where average operating margins are closer to 30%, and
- Another new market or two, with as much potential as the AI market, would also need to come along.
Could all of the above items end up occurring? Sure. Do we want to invest in Nvidia based on the hope that the above conditions all come to pass? Probably not.
Northwood’s public equity managers have generally shied away from investments in companies like Nvidia, where many future successes have already been built into today’s stock price valuation, and a failure for any of them to come true can lead to a significant loss in value. NVIDIA may be an excellent business, but is it an excellent investment at today’s valuation? Almost any business can be a good investment – but only at the right price.