Large tech stocks have soared again this year to date. Investors who’ve not held them may fear they’ve missed out, but before jumping in it’s important to consider the scenarios that must unfold for these stocks to continue to deliver. As our sister company, Orbis, explains in this article from 31 August 2023, valuation always matters if you’re looking to outperform over the long term.
Investing is hard. Seeing a stock you own fall in price and resisting the itch to sell takes a strong stomach. Seeing stocks you find expensive soar without you is no fun, either. It takes discipline to tame the fear of missing out.
Today that fear centres around the market’s obsession with artificial intelligence and the so-called “magnificent seven”: Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla. As a group, they are up 65% year to date. Standout winner Nvidia has soared by nearly 240%, while Microsoft delivered the lowest return—a mere 37%.
It doesn’t surprise us that we have missed some big winners this year. We always do, even in our best years. We’d love it if every share we bought was a winner, but we are not trying to buy every winning share. In the last six months alone, at least 82 investable stocks have returned more than Microsoft’s 37%. Excluding the tech giants, that’s ten other magnificent sevens, and we’ve owned several of those stocks. But the median stock in that group is valued at only $9.2bn. If seven companies of that size rise 37% each, they will contribute a grand total of 0.03% to the return of the World Index. In any period, there are lots of big winners, and lots that we miss. It is rare for them to be seven of the biggest companies on earth.
But the magnificent seven are among the biggest companies on earth, and they have moved markets materially. Across the Orbis portfolios, we have favoured mid-sized companies over giants, international firms to those in the US, value over growth, and banks over tech. Year to date, giants have squashed mid-sized companies by 6%, US businesses have beaten foreign ones by 9%, growth has outrun value by 22%, and tech has trounced banks by 36%. Yet our long globally-oriented strategies have nearly kept pace with their benchmarks, lagging by less than 3% net of fees. Idiosyncratic stockpicking matters, and while we have missed some headline grabbing winners, plenty of our lesser-known stocks have quietly thrived.
A few years ago, Nvidia was lesser-known, too— at least outside of gaming and crypto circles. AI enthusiasm sparked by ChatGPT has changed that. As the designer of the leading AI chips and the programming platform used to build software for them, Nvidia is seen as the biggest beneficiary of AI growth. The results are real—Nvidia’s revenue last quarter was double the level of a year ago. For an already-huge, highly-profitable company, such rapid growth is astounding. Well done to them.
Having doubled revenues this year, investors expect the company to grow by at least 30% p.a. for years to come. The rub is, that growth potential is now clear to everyone! So those expectations are already reflected in today’s valuation. The company has to deliver exceptional growth just to justify its current price.
Today that price is high. After a mad dash by brokers to increase their forecasts, the stock trades at 17 times estimates for next year’s sales. That’s 17 times next year’s top line, before any expenses. When a big stock trades at these levels, commentators dig out a quote from Scott McNealy, former CEO of Sun Microsystems. McNealy reflected on the valuation of his own company, which reached ten times sales during the 2000 tech bubble. Having laid out assumptions that make it sound impossible to profit from a stock trading at ten times sales, he asked investors, “what were you thinking?”
What investors were probably thinking (if they were thinking) is that Sun would grow very quickly. We’ve written before that paying ten times sales for a business is generally a bad idea. But it’s not impossible for a company to live up to the sort of growth now expected of Nvidia. Just exceedingly rare.
Since 1990, only about 230 companies in the FTSE World Index have ever grown revenues by more than 30% p.a. over five years (a near-quadrupling of sales). That’s 7% of the 3,400 relevant stocks that were in the Index. The feat is rarer still for already-huge companies. Only 45 businesses have ever delivered that kind of growth after cracking the top 200 of the Index, or just 6.5% of relevant companies that were ever that big. The hit rate is higher for expensive companies, suggesting markets do have some efficiency. 23% of huge companies trading at more than 10 times sales have gone on to sustain 30% p.a. growth. But that is less encouraging than it first appears. The flip side is that three quarters of the time, it doesn’t play out. Three quarters of the time, huge expensive companies don’t deliver the exceptional growth expected of them.
This month was a reminder that it is hard to exceed high expectations. Having rocked the market with its results and outlook just three months ago, Nvidia did so again in August. Sales and guidance both exceeded estimates by more than 20%. Yet the next day, the stock closed flat.
Valuations always matter, and they reflect expectations. The market’s shrug suggests that much of Nvidia’s future growth is already priced into the stock. To justify its current price, the company must deliver mind-bending growth. To hit brokers’ price targets, its growth must accelerate from mind-bending to mind-blowing.
Maybe it will—its recent results have been stunning. But we much prefer to invest in companies that trade at discounted valuations, and are trying to clear a lower bar. While the magnificent seven are great businesses, we’ve found several dozen companies that we believe will be more magnificent investments.
Financial advisers can contact their local Business Development Manager to learn more about the Orbis Global Equity Fund (Australia Registered).