Peter Brown: Investing in the ‘Magnificent 7’ is just too risky

Earlier this week, Apple shares fell while Meta and Amazon soared on key earnings.

The group of stocks known as the “Magnificent 7” which includes Apple, Microsoft, Amazon, Nvidia, Google-owner Alphabet, Tesla, and Meta which owns Facebook, make up nearly 30% of the S&P 500 index.

The group trades on an average price to earnings ratio of a whopping 46. If you buy that group of stocks, you are paying 46 years’ worth of current earnings for it. 

Historically that is an astonishing valuation for any company. We would regard a value stock investment to have a ratio of no greater than 15.

Paying a high price for something isn’t always a bad thing. You must look at the price of a company relative to its growth rate to see if there is any real value on offer or not. 

If you buy a company at 50 times earnings but it is growing at 150%, then it is cheap relative to its growth rate. If you pay 50 times earnings for a company growing at 25% then it is expensive relative to its growth rate.

India’s debt, for instance, trades on a high valuation, but it’s worth it because it is growing rapidly. By 2027, the IMF predicts that India will be the world’s third largest economy.

Many Irish pensions and other passive general investment schemes have the largest equity exposure to the Magnificent 7 stocks for no good reason.

US equity indices have the largest market cap in the world, so they get the highest allocation for that one reason alone. 

Price is what you pay, but value, or lack thereof, is what you get.

When you pay a lower price for something, there is a higher margin of safety built into the investment.

Just to avoid any misunderstanding, Amazon, Google and Meta are not included in the so-called info tech sector in terms of the US index, but are part of the consumer discretionary and communications sectors.

There is far too much exposure to tech stocks in the S&P 500 index, which means there is far too much exposure to tech companies in most standard and passively invested pensions and personal portfolios.

What's your view on this issue?

You can tell us here

Tech shares have been driven by the prospects for artificial intelligence, or AI.

Yes, there is a potential for artificial intelligence (AI) to change the world. But looking back to 2000, the tech-heavy Nasdaq Index correctly foreshadowed what was to come in the next 20 years, but failed to predict its own drop of 83% from its peak to trough in less than two years.

Scott McNealy, former chief executive of Sun Microsystems, was one of the darlings of the dot com bubble.

He subsequently noted that at 10 times earnings, to give you a 10-year payback, his company must pay out 100% of earnings for 10 straight years in dividends.

“That assumes I can get that by my shareholders.

“That assumes I have zero cost of goods sold, which is very hard for a computer company.

“That assumes zero expenses, which is really hard with 39,000 employees.

“That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal,” he said.

He also said that the valuation assumed a “zero R&D for the next 10 years, I can maintain the current revenue run rate”. 

“Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking,” he asked.

I am not saying that the Magnificent 7 are heading the way of Sun Microsystems.

But it is hard to justify buying or holding a stock that when a correction or revaluation comes, could adjust by up to 50% and still be regarded as overbought. How would I explain that trade to a client?

 Peter Brown is managing director of Baggot Investment Partners