The recent rebound in growth means that valuation spreads have widened to extremes once again. While the obvious, eye-catching prizes like the Magnificent Seven can be tempting, we explain why it can pay to dig deeper. There are plenty of opportunities waiting to be lifted out of obscurity.
In 2022, the combination of higher inflation, higher interest rates, and falling growth stocks meant it looked like the post-GFC cycle had turned.
As the ‘Everything Bubble’ deflated and momentum shifted from in-demand crypto, tech and meme stocks to more fairly-valued areas, many investors—including us—worried about recessions and more pain to come. But the breakout success of ChatGPT saved the day and allowed the ‘Everything Bubble’ to defy gravity by causing a huge reversal in sentiment—particularly for the ‘Magnificent Seven’ of Apple, Microsoft, Alphabet, Amazon, Meta, Tesla and Nvidia.
In 2023, these seven companies alone accounted for almost 70% of the S&P 500’s gains1. And the better they did, the bigger they got, and the more they contributed to index returns. So, investors who stuck with index trackers and passive funds enjoyed a fantastic year.
So much so that the 2022 rebound in value, which at first looked like the start of a new cycle, now looks like a blip in a 17-year long trend of growth crushing value. Although it’s important to keep in perspective that that trend is itself a bump in the road of value's 200-year track record of outperformance.
In the current environment, however, growth’s rebound means that valuation spreads—the gap between the ‘haves’ and the ‘have-nots’ as the market sees them—have widened to extremes once again. At times like this, the big fluffy toys can look like the easy win, but it often pays to look for equally appealing opportunities that are hidden in the background waiting to be lifted out of obscurity.
But today’s landscape is more complicated than what it might seem. The ‘Magnificent Seven’ (with the exception of perhaps one or two) are proven businesses with high margins, high returns on capital, and high growth. So it becomes easy to dream of seemingly endless AI-driven demand for Nvidia’s chips, and the products and services the other six will build using them.
This stands in sharp contrast to the TMT era and the ‘Everything Bubble’, when animal spirits were ablaze and investors were drawn to unproven business models with catchy names.
But against this backdrop one thing remains certain: expectations matter.
The market’s expectations can get ahead of even the best businesses, so that even if things turn out well, they may not turn out well enough—putting shares at risk. And with the index so unusually concentrated in the ‘Magnificent Seven’, a passive approach puts investors at risk that the weight of high expectations becomes too much to bear.
By contrast, as contrarians, we seek out areas where the market’s expectations fall short of what we think a business is worth. You might have heard the phrase “the secret to happiness is low expectations” well we embrace that in how we invest.
