Columbia Threadneedle Investments: Mag 7 – #Supersize Me

It was a 2004 documentary on the US fast food industry that introduced the phrase ‘Super Size Me’ to the lexicon. It tracked the effects of unchecked over-consumption of fast food on an individual’s physical and psychological wellbeing. Twenty years later and equity investors are undergoing a ‘Super Size Me’ type journey of their own. This time the excess consumption centres on a narrow cohort of US companies and the damage being wrought is a distortion in stock valuations and a concentration in the source of index returns.

This elite group of companies, dubbed the ‘Magnificent Seven (or even ‘Mag 7’)’ consists of  Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla. Most of them are household names. Nvidia is perhaps the exception. Although founded 30 years ago, this overnight sensation was little known outside of its niche tech community until just a few years ago. On 14 February 2024, the Santa Clara, California, based AI chipmaker, sealed its fast-tracked domination to become the third most valuable US company, eclipsing Google-parent Alphabet, just after overtaking Amazon. It’s share price rose to deliver a valuation of $1.825 trillion², while Alphabet’s value stood at $1.821 trillion³. The share price of Nvidia has tripled over the past year.

The growing popularity of lower cost (relative to active management) index investing has and continues still, to fuel the rise of the Magnificent Seven. As passive investment funds have taken in new money, they have simply accepted the prevailing share price when making purchases. Further, the more a company is valued the more a passive investment fund will buy of that company, creating an upward spiral in prices that makes no objective assessment of its value.

A highly concentrated market

Five of the Mag 7 stocks come from the tech arena (even if they are not classified as such by investment industry definitions) and that sector was outperforming generally anyway. This has rendered such strong momentum that it has driven new levels of concentration. In the most extreme of cases the valuation of some of these companies now exceeds the market capitalisation of a G7 nations’ total listed companies. (Apple, Microsoft and now Nvidia are all bigger than the total listed companies of the UK, France and Canada)⁴. Looked at from another angle, about 70% of world market capitalisation is now attributed to US stocks. By all measures the US economy is big and more robust than most of its peers, nevertheless it still only accounts for about 18% of global gross domestic product – a wide gap with its stock market ascribed worth. According to analysts at Deustche Bank⁵, the S&P 500 is now at its most concentrated in at least 100 years, posing risks and spillovers for other assets.

When concentration gets this extreme, speculation about the bubble bursting inevitably arises. When this has happened, it has tended to give way to some years when active managers, particularly those investing based on value, enjoy a bull run. If the public loses trust, amid the chaos of a burst bubble, and money starts to flow out of index funds this could speed a share price collapse as fast as the ascent. A heightened regulatory regime and public scrutiny of big tech companies, and AI in general, as well as geopolitical factors are among headwinds waiting in the wings.

Electric autos maker Tesla sits outside of the tech grouping but it faces its own challenges, not least the rapid emergence of greater competition in the electric vehicle field. China’s BYD reportedly surpassed production levels achieved by Tesla in the final quarter of 2023⁶ and aggressive discounting programmes could boost the manufacturers presence in price conscious overseas markets.

Investing while waiting

Comparing charts of equal-weight indices, which neutralise the concentration effects of larger companies, with market cap weighted indices, it is clear that equal weight markets outperform over the long term. It is also true that avoiding the largest stocks has been a sensible approach when concentration levels have peaked. This is because for the most highly valued companies much of the good news is already priced-in to its share price at that point. The years following the dot.com bubble burst of 2000, for instance, were glory years for value managers and in many ways established the power of the hedge fund sector. This was an era when good stock-picking was rewarded and when there were lots of undervalued stocks poised and ready to outperform the market.

Periods when the equal weight measure markedly underperforms tend to arise amid points of serious stress or bubbles (such as the Global Financial Crisis, the Covid pandemic, the Gulf War of 1990-91 and dot.com bubble). Since March of last year, we have seen the equal weighted S&P 500 and MSCI World noticeably underperform their market cap weighted versions⁷. This is without any apparent significant stress in the world, so does this point to a bubble or just interpreting too much about historical relationships?

While the market waits for the Mag 7 bubble to burst or run out of steam, we continue to remind our investors of the virtues of diversification and demonstrate why the biggest stocks, by market capitalisation, do not always generate the best returns over the long run.

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