5:27 PM PT
Olympia, WA
The last 15 years will likely be considered an anomalous time in markets. The S&P 500 has had a strong surge of outperformance over Emerging markets:
Within the S&P 500, tech has outperformed the rest of the sectors:
And, more recently, tech has been dominated by a small number of names, now called the Magnificent Seven, which consists of Apple, Microsoft, Google, Meta, Amazon, Nvidia, and Tesla.
Last year looked like a year of returning to normalization, but that quickly reversed as this year the market got even more narrow as the outperformance of the Magnificent Seven has carried the broader index. The chart below from a few weeks ago by Jim Bianco shows how much of the topline S&P 500 index return is due to the Magnificent Seven’s performance. If you were to remove them from the index, the index would be up less than 3% for the year.
This market dichotomy has made it very difficult for active investors like ourselves. Active investors try to get an edge through conducting deep fundamental research, identifying individual investments or asset classes that offer the best risk/reward, and constructing rigorous portfolios, but in 2023, your degree of underperformance or outperformance ultimately comes down to a single decision – how much of your portfolio are you investing in the Magnificent Seven? With the Magnificent Seven now making up 30% of the S&P 500 index, this is a challenging question because anyone that believes in diversification will find it very difficult to justify having that same level of exposure and even more difficult to be above that level of exposure.
As I am looking at things now, the main question is – will the Magnificent Seven continue to outperform? Or will we see a reversal? As I’m sure everyone is aware, the Magnificent Seven didn’t just become the Magnificent Seven for nothing. These are some of the best companies in the world. All of them are leaders in their industries and they produce massive amounts of cash flow. Each company is unique in its own way, but I believe there are some key benefits these companies have had that may be reaching their expiration date.
One way to view the economic cycle is through the lens of capital vs labor. For the past 40 years, government policy has been very supportive for corporations and for capital. Pro capital policies have been a big support to US multinationals and have supported the near monopolistic prowess of these companies. A big hindrance to the continued dominance of the Magnificent Seven could be a structural shift to more pro-labor-oriented policies. The beginning of the pro-capital shift 40 years ago has relevance to what we’re seeing today. Coming out of WWII, after a brief period of re-organization in the economy to accommodate the return of the troops and all the changes that the end of WWII brought, the US, and many parts of the world more broadly, entered a time that was supportive of the worker. Support for unions and the formation of unions had a notable increase and worker compensation moved steadily in line with increases in economic productivity. Unfortunately, all good things must come to an end. The result of labor having the advantage over capital for a prolonged period of time is that it leads to inflation and economic stagnation as we saw in the 70’s. An almost symbolic end of this period was when, in 1981, the air traffic controllers’ union went on strike, and in response, the Reagan administration fired 11,345 of the striking air traffic controllers that refused to return to work. Public sentiment had shifted as well, as support for labor unions was at the lowest level it had ever been since Gallup started tracking it.
This kicked off a 40-year period of pro-capital policies that resulted in one of the biggest financial booms in history. However, as pro-labor policies resulted in inflation and stagnation, pro-capital policies have resulted in significant income inequality. Now, in the opposite direction of the Reagan administration cracking down on union strikes, we are seeing President Biden marching alongside UAW strikers, supporting their demand for higher wages. Perhaps that will be symbolic of the start of a pro-labor period. The political tides have been shifting, and there is an increasing preference toward socialism over capitalism among many voters now that would have been unheard of 40 years ago.
This shift opens up a can of worms that could have many implications for the Magnificent Seven and larger US multinational companies more broadly. Over the last several years, we have seen capital flow data being distorted in a way that doesn’t quite add up. Work by Brad Setser and Russell Clark has revealed that a big reason for this is that US multinationals are taking advantage of tax havens, predominantly in Ireland, but also in other jurisdictions, to an extent that it is obscuring overall capital flows data. One of the main tax mechanisms in place is through Ireland. Ireland allows for intellectual property assets to be capitalized and written down to generate a capital allowance. This tax mechanism, part of an adjustment to Ireland’s BEPS structure, has driven a huge flow of intangible assets and profits to Ireland since the amendment in 2015.
This type of policy is interesting because it mainly just benefits US multinationals as the US is the only major nation to still work on a worldwide tax basis. This benefit is at the expense of foreign companies and US companies that only operate in domestic markets. The effect of this can best be seen in the chart below by Brad Setser.
Allowing this type of policy made sense when Ireland was an economically undeveloped country, but now Ireland has developed its economy to the extent where it no longer needs to be a tax haven to support its economy. Additionally, we are seeing the OECD introduce policy changes to eliminate or alter these tax haven models. We will have to see how these changes develop, but the overall pro-labor sentiment shift appears to be strongly moving against this tax haven model that has been a big benefit to the Magnificent Seven.
Another concern for these companies that a pro-labor shift would introduce is the impact of anti-trust legislation. Anti-trust concerns are becoming more prominent, and this is making certain growth strategies for these companies less viable. One popular strategy used by these larger companies, the roll up, is already facing backlash. A roll up is simply when a larger company acquires other companies, predominantly emerging companies and competitors. These acquisitions are done either to add exposure to a segment that is in a high growth phase or to eliminate what would be an emerging competitor. These roll ups have been done in high frequency by Microsoft, Google, Amazon, and Meta over the last several years and have been a key source of these companies remaining dominant in what is typically thought of as a disruptive industry. Now, the tide is beginning to turn against this strategy. It is being argued by many people that the roll up strategy is stifling competition and muting innovation. In recent years, this has drawn more attention from regulators and politicians. Lina Khan, the FTC chair, has addressed this many times, and she appears to be taking a more aggressive regulatory stance than what we have seen previously. She discussed recently how regulatory considerations are being brought to the forefront of companies’ decision-making processes now, as opposed to it having been an afterthought. Microsoft’s recent acquisition of Activision did get approved, so the roll up strategy is not dead yet, but getting the approval was a much greater challenge than what we have been used to seeing. Public and political concerns around AI development are only adding to these risks. The underlying current appears to be moving against the roll up, and I would not be surprised if we begin to see more acquisitions blocked by regulators.
That brings us to another challenge these companies have been dealing with – a slowing of innovation. This certainly doesn’t apply to all of the Magnificent Seven, but I would say it definitely applies to Apple, which is the largest and most important company in the stock market, valued at close to $3 trillion. I can personally attest to this as I recently upgraded from the iPhone XS to the new iPhone 15 Pro. I’m not a frequent upgrader as many people are. I was actually perfectly content with my iPhone XS, but I had been capped out on storage for some time and that was making it so I couldn’t download any of the new updates or any more apps. Now that I have the latest and greatest iPhone, my experience with the new phone so far is that it is essentially the same phone as the iPhone XS, with very little that is better or even much different. Looking at the competitive field, the competition does appear weak. Android phones have been steadily innovating, but they haven’t caught on. We are seeing this among teens as recent studies have revealed that 88% of teens want their next phone to be an iPhone. However, this will likely not be permanent. We saw recently that there is room for competitors in the smartphone space. Huawei, China’s leading smartphone company, had rapid adoption when it was initially released (even the intern at our office at the time had one), but we quickly saw an end to that when the US banned the use of Huawei phones under suspicion of espionage. The ban kept Apple at the top, but the brief rise of Huawei showed that competitors are capable of emerging. With innovation muted, we will likely see emerging competitors in the future.
In line with the pro-labor shift, we are now dealing with higher inflation and higher interest rates that could be stickier than expected. This is negative for the Magnificent Seven as it blunts one of the key methods in which these companies have been utilizing to return capital to shareholders. To return capital to shareholders without repatriating revenue from tax havens, these companies have been issuing debt in order to do share buybacks. As a financial engineering mechanism, share buybacks are beneficial to the company’s capital structure when the earnings yield, or the inverse of the P/E multiple, of the shares is higher than the yield on the debt that is issued. This was the case up until 2022. Now, because yields on debt have moved much higher, when debt is issued to buyback shares, it is negatively impacting the company’s capital structure because bond yields are now higher than the earnings yield. This strategy still works as a way to return capital to shareholders, but it no longer makes sense from a financial point of view. This has been a key strategy of a few of the Magnificent Seven companies to return capital to shareholders, but now it is one less support for the share prices.
These risks are emerging at a time when valuations for these companies are at historical highs. High valuations do not necessarily mean it is impossible to get a good return as an investor, but it makes it much less likely.
Should these shifts continue, it suggests to me that we may be entering a period where foreign companies and domestically oriented US companies will be back on even ground with the growthier US stocks that have been capturing a lot of foreign revenue. The Magnificent Seven, in particular, could certainly remain strong companies, but given their lofty valuations and the degree to which they have benefited from structures that could be expiring, it looks like growth in their businesses as well as in their stock prices could be more challenging going forward. Timing is always an unknown on when this will all flow through. It could be two months from now or it could be two years from now, but I do believe a reversal is ahead.
