It’s been an interesting year for global equity markets. Listening to different managers – each with their own perspective – you’d be forgiven for thinking it was a bleak picture. Yet underlying returns have been reasonable, with global equities up just shy of 15% in US Dollars to the end of August.
Most of this has been driven by the Magnificent 7, which includes the likes of Apple, Microsoft, Alphabet (Google) Tesla, Amazon, Nvidia and Meta (Facebook). A revered list, dominated by mega-cap US tech shares. Of course, most of these names have been closely linked to and driven by the hype surrounding Artificial Intelligence (AI) and the narrative that it will change everything.
Those seven shares alone are equal to roughly double the size of the entire stock markets of South Africa, India, Brazil, and Russia combined. Part of this sheer magnitude has been their share price performance this year. An equally weighted portfolio of the Magnificent 7 would have nearly doubled to the end of August, up a colossal 94%. Just those seven stocks have driven nearly two thirds of their entire market gains, which is extremely narrow given that there are nearly 3,000 shares in the main global equity index (MSCI ACWI). That means the broader market return has looked pretty pedestrian in comparison.
Figure 1: The combined market cap of the Magnificent 7 vs combined market cap of Brazil, Russia, India and SA
Source: Bloomberg to 30 September 2023
Given this narrowness, how sustainable are these returns? September is a good indication of what happens when markets question this, with global equities down close to 5% in USD, led primarily by the names that had run so hard and steered the direction of travel.
It’s interesting and very important for investors to bear in mind that while you’ve still made a lot of money from these shares this year, most of the returns have come from a re-rating. In other words, people are paying more for the prospective expectations of returns rather than the actual earnings growth you've had. If you look at the earnings for those stocks, they are only up 27%, which while impressive, does beg the question whether those meteoric share price gains are warranted. Could investors just be paying up in hope?
That’s the issue. You’re playing an expectations game. The questions must be asked, is this Artificial Intelligence or Artificial Valuation? These shares hardly look cheap. So, if earnings are what you're paying for, you had better be sure that the earnings growth is going to come through. And when you look at the market caps at 8 to 9 trillion dollars tied up in these names, work out how much revenue growth these companies are able to deliver from that starting point. It’s possible they start cannibalising each other's business, and there are significant losers. All this against the backdrop of a looming recession and general economic headwinds.
No matter how good the story is that that the management sell at the end of the day, the free cash flow and the earnings evolution have to match that story. Where that is the case, we're very happy to invest, because we are positive on those prospects. But where shares run ahead of those expectations, we advise caution. You need to ask really good questions about how you're going to make investment returns on a prospective basis.
There are so many ways to invest in AI. As Mark Twain famously said, “When everyone is looking for gold, it’s a good time to be in the pick and shovel business.” We don’t think people realise how many different investable companies there are that allow you to take part in this revolution. Two businesses we own in the Ninety One Global Franchise portfolio, for example, play behind the scenes and are less dependent on who wins the AI race in the headlines. Samsung, for example, is involved in the production of semiconductors or chips required for AI development and other tech-related initiatives, so it’s more than just televisions and microwaves. ASML has a near monopoly in the development and manufacturing of photolithography machines, which are used to produce computer chips. They provide the infrastructure behind the infrastructure. The machines behind the machines. They don’t care which app wins.
Ultimately, you have to be sure that what you pay today is what you’re going to get in the future. Microsoft and Google, which we also own and are more closely linked to the frontline of AI, have business models that have been proven. They continue to disrupt and innovate and trade at valuations that are palatable. While they benefit from the AI theme and are meaningful players in this space, they are not solely reliant on it to grow. We can get behind these sorts of businesses.
