How Magnificent are the Magnificent Seven?

  Horacio Coutino, Equities investment writer

Every 3 to 5 years, an acronym or catchy phrase becomes embedded into the financial global discourse. The most recent is the “Magnificent Seven”, a group of 7 companies all listed in the Nasdaq, and part of 3 GICS sectors: Communication Services (Alphabet and Meta Platforms), Consumer Discretionary (Amazon and Tesla), and Information Technology (Apple, Microsoft and Nvidia). The Magnificent Seven are supposed to be best positioned to develop the necessary infrastructure to transform consumption patterns, from electric vehicles to artificial-intelligence driven experiences to hardware ecosystems, powered by state of the art microchips.

As the Magnificent Seven (M7) continue to grab financial news headlines, we take a closer look, starting with the events in Q1 2024, to really understand what is driving sentiment. We also consider:

• Market concentration
• Performance
• Volatility
• Profitability
• Valuation from an EV/EBITDA multiple perspective

The M7’s Q1 2024:

Alphabet

• Stalled AI launch. Alphabet's attempt to compete in the generative AI space faltered with the launch and subsequent withdrawal of its image generation tool within their Gemini suite.
• Search Dominance at Risk? The potential of Large Language Models to disrupt traditional search raises concerns for Alphabet's core business model.
• Monetisation Strategy. While Alphabet explores new ad formats for generative AI searches, they currently lack a subscription-based model akin to competitors like Microsoft 365 or Amazon Prime.

Amazon

• Prime Video Ads. Amazon added ads to their Prime Video streaming service on 29th January, aligning with competitors.
• iRobot Acquisition Halted. The company's $1.7 billion acquisition of iRobot was terminated in January due to EU antitrust concerns.
• Rufus Debuts. Amazon launched a new AI-powered conversational shopping experience called Rufus in beta testing for select mobile app users in February.
• Dow Jones Inclusion. Amazon was included in the Dow Jones Industrial Average on 20th February.

Apple

• China Market Decline. iPhone sales in China, Apple's second-largest market, declined due to government restrictions on iPhone use and increased competition.
• Autonomous Vehicle Project Scrapped. Apple shifted focus from developing an autonomous car to prioritising AI research.
• EU Antitrust Fine. Apple received a €1.8 billion fine from the European Commission for anti-competitive practices within its App Store related to music streaming services.
• AI Strategy Unclear. Despite existing smart assistant technology (Siri), Apple's overall plan for integrating AI into its products and services remains elusive for investors.

Meta Platforms

• Enhanced Financial Performance. Meta announced its first-ever cash dividend of $0.50 per share and a $50 billion increase in its stock buyback program, reflecting a focus on shareholder returns after a period of cost-cutting.
• AI Investment. Meta outlined plans to integrate generative AI into its platforms, signalling significant capital expenditures in this area.
• Regulatory Scrutiny. Mark Zuckerberg faced pressure from US lawmakers regarding online child safety, culminating in a public apology during a Senate hearing.

Microsoft

• Copilot key. Marking a significant shift in PC keyboard design, Microsoft introduced the Copilot key on January 4th. This dedicated key grants users seamless access to the Copilot in Windows software.
• Regulatory oversight of generative AI. The Federal Trade Commission (FTC) issued inquiries on January 25th to several companies, including Microsoft. The inquiries request information on recent investments and partnerships involving generative AI firms and major cloud service providers.
• Microsoft Q4 2023 earnings. Microsoft's earnings report delivered positive results, exceeding expectations in revenue, earnings per share (EPS), and Azure growth. However, tempered growth within the Office 365 Suite subdued overall optimism.

Nvidia 

• Nvidia’s shares soar. Nvidia's stock price has seen exceptional growth, exceeding 80% gains in under 10 weeks and propelling market capitalization by over $900 billion.
• Strong Q4 earnings & future guidance. The company's Q4 2023 earnings surpassed expectations, indicating robust demand for AI products despite increasing supply. Similarly, Q1 2024 guidance exceeded analyst predictions, with upcoming product cycles anticipated for AI training, inference, and networking.
• AI growth & diversification. The earnings call highlighted an industry shift towards accelerated computing and generative AI. Inference, the fastest-growing segment, is experiencing diversification into new sectors like automotive, healthcare, and financial services.
• Challenges ahead. Potential future challenges include ongoing supply shortages, competition from hyperscalers and others, and potential gross margin pressure due to high component costs.

Tesla

• Structural challenges. Tesla faces slowing demand for electric vehicles (EVs) in the US, and is under pricing pressure from competitors like BYD in China and other markets.
• Poor guidance. FY 2024 guidance indicates notably lower vehicle volume growth compared to 2023. This raised concerns about future growth, particularly regarding execution risks of the next-gen modular manufacturing approach.

Concentration

Among the M7 companies, all are dominant players within their respective industries, significantly contributing to their corresponding S&P 500 GICS Sectors. The most concentrated sector is Communication Services, where Alphabet and Meta Platforms' market capitalization accounts for more than 75% of the index. Similarly, in the Information Technology sector, Microsoft, Apple, and Nvidia collectively represent over 60% of the index's market capitalization. Finally, the Consumer Discretionary sector is heavily influenced by the M7, with Amazon and Tesla's shares constituting more than half of the index. The total market capitalization of the M7 as a share of the total market capitalization of the S&P 500 Index has almost doubled in just 5 years, from 16.7% to 30.7%.

The dominance of the M7 within the US equity market is further accentuated by their prevalence across Exchange-Traded Funds (ETFs). A comprehensive analysis of ETF holdings within the S&P 500 reveals that six of the M7 companies rank among the top ten most widely held constituents. Microsoft, Nvidia, and Apple take the leading positions, being included in a staggering 335, 311, and 294 ETFs, respectively. This significantly surpasses the average ETF membership for S&P 500 constituents, which stands at 141, with a median of 136.

The elevated number of ETF holdings for the M7 signifies that their shares are consistently selected based on the specific criteria employed by each ETF. These criteria often prioritise passive investment strategies, which are characterised by lower portfolio turnover compared to their actively managed counterparts. The M7's inclusion in a vast array of ETFs may indicate that their shares are less susceptible to frequent buying and selling activity within these funds, reflecting a more stable long-term investment proposition.

Performance

We examine their performance relative to their specific industry sectors. This approach allows us to:

• Identify Outperformance. We can pinpoint which M7 companies are exceeding expectations within their respective sectors. This could indicate superior execution within the industry or a particularly strong market position.
• Sector Trends. Analysing sector performance for the M7 can shed light on broader industry trends. 
• Risk Diversification. By understanding the M7's performance within their sectors, we gain insights into the diversification of their overall risk profile.

For the past 3 years, Nvidia has outperformed the rest of M7. Tesla's performance has diverged from its peers within the Consumer Discretionary sector, underperforming the sector’s benchmark by almost 30% from Q1 2020 to Q1 2024. Amazon’s overall performance over the period has remained below its sector. Conversely, the Communication Services sector witnessed significant outperformance by Alphabet which was only eclipsed by the 60% rise in Meta Platforms performance from November 2023 to Q1 2024. This meant Meta Platforms' three-year performance surpassed Alphabet's by over 5%, fundamentally altering the competitive landscape within the sector.

Beyond traditional performance metrics, the ‘surprise factor’ offers insights into a company's financial and strategic prowess. Defined as the percentage difference between analyst estimates for a specific financial metric and the actual reported value, the surprise factor is most commonly applied to EPS. However, its utility extends to other closely watched profitability indicators such as EBITDA.

Source: Factset and Exante research

A positive surprise factor indicates a company's ability to outperform analyst expectations. This often reflects strong underlying fundamentals, such as a robust business model, efficient operations and a clear long-term strategy.

Examining the M7's performance since Q1 2020 reveals a divergence in their ability to generate positive earnings surprises. Nvidia, Meta Platforms, Microsoft, and Amazon have consistently exceeded analyst expectations for both EPS and EBITDA. This consistent outperformance has likely bolstered investor confidence and contributed to their strong stock performance.

Tesla stands out as the sole M7 member with a negative average EBITDA surprise factor in all four quarters of 2023. While both Alphabet and Apple exhibited diminishing surprise factors for EPS and EBITDA, it's important to note that these factors remain positive. However, a sustained decline in surprise factors could dampen future investor sentiment.

Nvidia's consistent ability to surpass analyst expectations, particularly regarding EBITDA, underscores its exceptional execution and strengthens its position within the market.

Volatility

A volatility analysis using the three-month standard deviation of daily price returns reveals Tesla as the most volatile member of the M7 from 2019 to 2024, followed by Nvidia. This heightened volatility is likely due to company specific factors such as their exposure to emerging technologies. The overall S&P 500 exhibits lower volatility due to its inherent diversification. However, during the peak of the pandemic selloff in 2020, both Alphabet and Amazon displayed standard deviations marginally lower than the S&P 500. This resilience may be attributed to their sound financials and robust business models, suggesting they are less susceptible to market whims.

Source: Factset and Exante research

Since 2023 there appears to be a heightened level of inter-sectoral volatility correlation within the M7. The correlation between Communication Services and Consumer Discretionary sectors is the strongest, reaching a coefficient of 0.92. The correlation between Information Technology and Communication Services, at 0.84, remains significantly elevated compared to traditional norms. This suggests that the price movements of these sectors have become increasingly intertwined, potentially due to shared exposure to certain economic factors.

Furthermore,the spread between the average volatility of the M7 and the S&P 500's volatility widened between 2022 and 2024, reaching 48 basis points in 2023 compared to 29 basis points in 2021. This indicates a period of heightened volatility specific to the M7 sectors, suggesting a potential divergence from the broader market. Surprisingly, 2020, a year marked by exceptional market volatility due to the pandemic, saw the lowest spread at just 14 basis points. This may be explained by the fact that during periods of heightened overall market volatility, sector-specific volatility tends to converge.

Both the Communication Services and Information Technology sectors, as of Q1 2024, exhibit the highest 3-month standard deviation of daily price returns, at 1.25% each, highlighting the heightened risk associated with these sectors.

Source: Factset and Exante research

Beta trends reveals M7's diverging risk profiles

An analysis of the M7's individual betas provides insights into their relative risk profiles. Since March 2021, the average beta for the M7 constituents has exhibited a consistent upward trend, increasing from approximately 1.01x to 1.49x by Q1 2024. This indicates that, on average, the M7's stock price volatility has become increasingly sensitive to fluctuations in the broader market. Notably, the beta peaked in October 2023 at 1.56x.

However, there’s a divergence in beta trends amongst M7 members. Apple and Amazon have witnessed the most significant decline in beta from the end of Q1 2023 to Q1 2024, at 1.07x and 1.52x, respectively. This suggests that their stock prices have become less sensitive to market movements.

Nvidia’s and Tesla’s betas exceeded 2.0 by the end of Q1 2024, at 2.25x and 2.10x, respectively. This elevated beta could be attributed to factors such as their growth trajectories, exposure to disruptive technologies, and heightened sensitivity to market expectations in their respective sectors.

Source: Factset and Exante research

Risk-Adjusted Returns: Beyond Price Fluctuations

How should investors reconcile performance and volatility? How does the volatility context influence price performance? Risk-adjusted returns, measured as the Sharpe ratio of each company in trailing annual returns and using the US Treasuries 10-year yield as the risk-free rate, captures this relationship.

Since the summer of 2023, the risk-return profile of the S&P 500 remained mostly in positive territory. Its annual risk-adjusted return (from Q1 2023 to Q1 2024) stands at 24.53%. The 2 outliers of the M7 are Nvidia (annual risk-adjusted return of 77.75%) and Tesla (annual risk-adjusted return of -4.49%), however Meta Platforms strong performance since October of 2023, has propelled its annual risk-adjusted return to 57.83%. The annual risk-adjusted returns (from Q1 2023 to Q1 2024) of the Communication Services and Information Technology Sectors are higher than the S&P 500, at 39.18% and 37.96%, respectively.

M7 Profitability: Unveiling Sector Leaders and Growth Drivers

Delving deeper into the M7 by sector can provide insights into their relative profitability. By comparing each company's margins to their corresponding sector averages, we gain a clearer understanding of their competitive positioning.

Information Technology: The role of AI, geopolitics, and cloud computing in tech sector profitability.

This sector boasts an impressive aggregate EBITDA margin of 31.4%. Its net margin profitability is nearly double that of the S&P 500 at 21.0%, with Nvidia currently the most profitable in the M7. Nvidia's EBITDA margin surpassed Microsoft’s, surging to a remarkable 56.6% in Q4 2023 from 26.4% a year earlier. Similarly, Nvidia's net margin sits at 48.9%. This is a considerable turnaround given that Nvidia's margins were below the sector average in 2022.

Nvidia's meteoric rise can be attributed to the explosion in interest from businesses and governments in Artificial Intelligence (AI) applications. It has also benefited from rising geopolitical tensions between the US and China as President Bident shifted US policy directives towards supporting US-based manufacturers like Nvidia instead of relying on Taiwanese and Chinese production.

Microsoft’s EBITDA margin has grown by nearly 10% from 42.04% in December 2018 to 51.8% in December 2023. This can be primarily ascribed to the sustained growth of their intelligent cloud, productivity, and business process segments.

Apple’s margin expansion has been more modest than its M7 peers. From Q1 2019 to Q4 2023, Apple's EBITDA margin has increased by 310 basis points, and its net margin by 400 basis points.

Source: Factset

Communication Services: Profitability powerhouses fueled by innovation and user engagement. 

Since the beginning of 2023, Meta Platforms has successfully reversed a downward trend in margins. As of Q4 2023, it boasted a robust EBITDA margin of 46.9%, a significant increase from 35.87% in Q4 2022. This expansion mirrored a similar rise in net margin, climbing from 19.89% in Q4 2022 to 28.98% in Q4 2023.

Meta fosters continuous user engagement through new features and app integration, creating a richer "social graph" that fuels data collection. This data allows for highly targeted advertising campaigns, reflected in Meta's growing ad revenue per user.  Furthermore, the company's strategic application of AI technology to its offerings and the launch of VR products hold promise for greater user engagement and, consequently, future advertising revenue growth.

Google, which holds more than 90% of the global online search market, generates exceptionally strong and consistent cash flow, as evidenced by its EBITDA margin averaging 31.4% since Q1 2019. Despite setbacks on its first effort to deploy its AI generative tool, given its controversies over historical inaccuracies and controversial answers, Alphabet remains well-positioned for continued growth. The ever-increasing number of online users translates directly into a rise in digital advertising spending, a trend that benefits Google. Additionally, Android's dominant market share in smartphones reinforces Google's control over mobile search, a crucial area for future advertising revenue.

However, Alphabet isn't without vulnerabilities. Firstly, a lack of revenue diversification makes them heavily reliant on Google and search advertising. Secondly, there are concerns about the allocation of significant capital toward high-risk ventures. Finally, and perhaps most importantly, Google's search market share faces increasing scrutiny from regulators. While Alphabet's net profit margin has fluctuated, peaking at 29.53% in 2021, as of Q4 2023, its standing at 24.03% remains healthy. However, continued dominance requires strategic navigation of these potential threats.

Source: Factset

Consumer Discretionary: Amazon's profitability drivers and Tesla's fight for EV dominance. The Consumer Discretionary sector stands out as the least profitable among the three analysed. This relative weakness stems from key factors inherent to the industries it encompasses. Price pressures are a constant battleground, the post-pandemic period has introduced ongoing supply chain challenges, and the competitive landscape is consolidating. As a result of these factors, the Consumer Discretionary sector exhibits lower profitability metrics compared to the broader S&P 500. As of Q4 2023, the sector's average EBITDA margin sits at 15.5%, and its net margin is 7.3%, both falling below the S&P 500's averages.

Amazon reigns supreme in e-commerce, leveraging its unmatched scale to offer a vast selection of goods. This, coupled with the powerful Prime membership programme, fosters a loyal customer base that benefits from expedited shipping, exclusive content, and other valuable services. This virtuous cycle attracts both consumers and sellers, solidifying Amazon's e-commerce dominance and contributing to its EBITDA margin hovering between 12.0% and 15.5% over the past five years.

However, Amazon's profitability story extends beyond e-commerce. Amazon Web Services (AWS) has established itself as a cloud service leader, and the company's advertising business, integrated with its streaming platforms, offers targeted access to a wide audience. These high-growth segments, AWS and advertising, are expected to outpace e-commerce growth and drive future profitability. While Amazon's net margin has shown some volatility, currently standing at 5.3%, the consistent EBITDA margins demonstrate the underlying strength and profitability of the core e-commerce business. However, Amazon faces potential headwinds from regulatory scrutiny, increased investments impacting cash flow, and challenges in replicating success in entirely new categories.

Tesla is racing to solidify its EV lead as the market transitions to mass adoption. New factories boost production capacity, while R&D investments exceeding 4% of sales fuel Tesla's technological edge in batteries. The extensive supercharger network is a key differentiator for Tesla – a network of fast chargers strategically located along highways and in urban areas across the US, EU, and China. Tesla has even expanded into auto insurance and software subscriptions, aiming for a bigger slice of customer spending.

However, Tesla's recent financial performance raises concerns. Despite a rising net margin over five years, the company's EBITDA margin has declined for four quarters straight, down to 14.0% by the end of 2023 This suggests potential challenges in maintaining profitability as competition heats up. Traditional automakers and new entrants threaten to decelerate Tesla's sales growth and force price cuts, eroding margins. Tesla's reliance on Chinese batteries for its affordable Model 3 could also hurt sales if they miss out on US subsidies. Additionally, a faster-than-expected decline in battery and solar panel prices could squeeze profits in Tesla's energy business.

Source: Factset

EV / EBITDA Multiple Valuation

Nvidia’s surge is reflected in its valuation. By the end of Q1 2024, it traded at about 100.1x EV/ EBITDA, complicating a reasonable comparison with its peers and sector. This is because the increase in profitability via its EBITDA margin hasn’t kept pace with the rise in its equity valuation. Excluding Nvidia, the Information Technology sector, as of the end of Q1 2024, traded at 26.2x, while its 3-year average stood at  20.7x. Apple traded at 20.6x, below its 3-year average of 21.9x. This was in contrast to Microsoft, which traded at 26.8x, 12.6% higher than its 3-year average of 23.8x and in line with the sector.

Source: Factset

At the end of March 2024, the Communication Services sector traded slightly above its 3-year average, at 12.6x. Meta Platforms traded at 19.8x, 38.5% higher than its 3-year average of 14.3x, while Alphabet traded just above its 3-year average of 18.0x at 18.4x.

Source: Factset

Tesla’s volatility is also reflected in its EV / EBITDA valuation. Its 3-year average stands at 81.2x, due to the growth valuation that characterised it in the past, ie, a high equity valuation despite low EBITDA. At the end of Q1 2024, it traded at approximately 39.9x, significantly higher than its peers. It also has a challenging growth outlook ahead, as its EBITDA margin has started to deteriorate. The consumer discretionary sector is the only sector of the three in the M7 that is currently trading below its 3-year average of 19.8x at 17.5x. From Q1 2021 to Q1 2024, Amazon’s performance has the wider sector performance, and currently trades at 22.5x, while its 3-year average stands at 25.3x.

Source: Factset

Conclusions

The M7 shares have had an extraordinary run since 2021, but a correction may be warranted. The market capitalization of the M7 raises concentration risks for investors. In addition, given their prevalence across ETFs, the price fluctuation of these companies may impact a wider range of portfolios.

While the M7 have largely outperformed the S&P 500, their performance varies significantly across companies and sectors. Despite the omnipresence of AI-mania, not all of the M7 are positioned to advance and lead the transition. Looking beyond price fluctuations and considering risk-adjusted returns may provide a more comprehensive understanding of investment performance to reveal significant divergence in risk-return profiles within the M7.

Volatility measures, such as the Beta and Standard Deviation, appear to be relevant factors when considering the M7. The M7's average beta has increased, indicating their stock prices have become more sensitive to broader market fluctuations.

Although the M7 are likely to continue to dominate the S&P 500 for the foreseeable future, questions over valuation, concentration, and overall risk management will continue to arise. This means that investors should also consider other markets as part of their diversification and risk management strategies. This includes considering the “European Magnificent Seven" or "Granolas" as they may, as noted by Morningstar, represent a much broader section of the wider European economy, thus reducing concentration risk. And, as they are also cheaper than the US Magnificent Seven, with a similarly solid performance, they may, in the longer run, be almost as attractive.

Overall, the M7 represents a powerful force in the market, but investors should be aware of the varying risk-return profiles, concentration risks, future prospects and potential headwinds faced by each company. Examining factors like volatility, profitability, and valuation alongside performance metrics is crucial for making sound investment decisions within the M7.

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