The warnings are common. The market is driven only by a handful of giant tech stocks and therefore rests on weaker foundations than markets driven by broader constituents. We think that view is lazy and misguided. In his Sunday column, Jim Cramer told members of his Investing Club that they should stop worrying about technology winning and learn to love it. Jim wrote that investors should stop thinking, “This will never last,” and think, “It will not only last, but will wait for other companies to join in.” That’s because the afterglow of the artificial intelligence boom is starting to kick in and will continue to benefit non-tech companies as well. But it’s still early days for club industries like Eaton and Dover to benefit from retooling and building data centers to handle AI workloads. Are great companies too great? In the meantime, what should we do? Tell investors to avoid the S&P 500 because the great companies in the index are simply too great. Do the so-called market experts who say so not see how absurd it is? Wouldn’t it be better if there was a 500-stock index made up of 500 average stocks? Where do you think the S&P 500 would be right now if it weren’t for the Super 6 mega-cap tech stocks you hold in your club portfolio? Does anyone think it would have been better if those stocks hadn’t outperformed? This whole story reminds me of something I’ve heard many times in 2022 when the market was being sold off as a result of decades of high inflation and the Federal Reserve’s interest rate hikes to combat it. I’ve heard asset managers and strategists appearing on CNBC many times saying that the companies that led the last bull market won’t lead the new one. That irritated me to no end. Not because it wasn’t true. It may indeed be true that historically the old leaders won’t lead again. No, because such a view has absolutely no bearing on the businesses of these companies or their underlying fundamentals. What does the end of a bull market on the back of inflation and Fed rate hikes have to do with earnings potential over the next few years? That’s what matters for the Super Six stocks — Amazon, Apple, Microsoft, Meta Platforms, Nvidia and Alphabet — and the evidence is in these stocks’ rally on easing inflation and preparations for the Fed to cut interest rates last year and so far in 2024. “Consensus forecasts suggest Big Tech revenue growth will continue to dominate in the second quarter of 2024,” Barclays analysts said Wednesday. [second quarter 2024], EPS expansion is expected to be almost +32% vs. +3.3% for the rest of the SPX.” Wow, that’s a huge difference and further evidence that it’s nonsense for long-term investors to care about random market trends over fundamentals. Companies don’t lose their edge or stock leadership because they were dominant in the last bull market. They fall behind because they get flustered, fail to innovate, or fail to adapt to customer demands. Did IBM fall because it was once the most valuable stock in the world? Or was it because the company failed to keep up with the latest data center and cloud computing innovations? Just like we’re seeing right now, the market is judged based on the price movements of stocks, not how the businesses those stocks represent are doing. Nvidia is up over 1,000% since October 2022, so what? The company’s valuation is still around 40x forward earnings, roughly in line with five-year expectations. That’s average. You can’t blame investors for taking profits every now and then. At the start of the year I sold Nvidia, Meta Platforms, Palo Alto Networks and five other tech stocks. On Monday I sold Meta and Palo Alto again. I say sold because it hasn’t changed my view of these great companies. I’m not paying attention to these great companies because they were doing well. It would be foolish to avoid the market because great companies are getting even better. To be clear, we’ve seen concentrated markets before and they don’t necessarily end in disaster, as expected. I’m not saying it can’t or won’t happen, I’m just saying we’re going to see extreme concentration again, which in itself is not a reason to avoid the market, especially for those who are invested in individual companies. Concentration vs. Diversification Some people would argue that concentration in these stocks is bad for diversification. But within the Super 6 are three sectors of the S&P 500: Apple, Microsoft and Nvidia in technology, Amazon in consumer discretionary goods, and Meta and Alphabet in communications services. These companies also have numerous businesses that serve many end markets. Amazon has several services, including a video subscription business, online shopping, cloud computing, delivery and logistics to rival United Parcel Service, advertising, home security with Ring and Blink, groceries, books, and music. Microsoft has cloud computing, consumer electronics, enterprise software, games, and search. Google’s parent company Alphabet has a myriad of potential businesses in development, including cloud computing, YouTube video streaming, search, shopping, travel, navigation, and self-driving cars with Waymo. Apple has a consumer electronics business that is expected to make nearly $300 billion in sales this fiscal year, and a services business that is expected to make nearly $100 billion. If Apple’s services were its own company, it would be in the top 50 of the S&P 500 by sales. Meta focuses on social media like Facebook and Instagram, but it also has a growing hardware business with its Reality Labs, and is a serious player in generative AI with the development of Llama 3. Nvidia, driven heavily by data center revenues, is a staple of all things tech as its software offerings rapidly expand and central processing units (CPUs) reach the limits of their ability to rapidly increase computing power year over year. That’s why Nvidia’s graphics processing units (GPUs) are in such high demand. We’re only looking at six stocks here, but there are many more companies driving the stock price rally than six. If we split the Super 6 into 15 companies and stocks, would the market suddenly be more invested in them? These are the same businesses, and they’re probably a little less efficient because they inhibit the ability to aggregate, analyze, and leverage data, but hey, at least it’s more than six stocks. Should that make us feel comfortable? In a commentary on Monday, we looked at a sum of the parts (SOTP) analysis of Amazon and concluded that the company could grow even more in the long term by investing its business units together rather than separately. The Market Mirrors the Economy It’s not a stretch to argue that what we see in the market mirrors the U.S. economy in many ways. If you’ve worked during Google’s Gmail or Amazon Web Services cloud outages, you know how important the infrastructure these companies have developed is to employee productivity. Every company in the world wants to become more efficient, but right now, the cloud computing, generative AI, and automation that these companies are delivering mega-cap offers will be the fastest way to do that over the next decade. Sure, these companies make up a big chunk of the S&P 500. But guess what? These companies also generate a big chunk of the index’s earning power. In other words, the market dominance of these few stocks is not a concern, because when you think about it, fundamentally it makes perfect sense. Increasingly, we leverage these companies because they’re mission-critical to businesses, and consumers know what they want before we do. This dynamic will only intensify as generative AI becomes more integrated into all these platforms. Valuations Soar Are these companies’ valuations a little crazy? As Jim pointed out in his Sunday column, in some cases they might be a little crazy. Apple trades at 32 times forward earnings, but its five-year average is 25 times. Microsoft trades at 35 times forward earnings, but its five-year average is 29 times. By comparison, the S&P 500’s three-year average multiple is about 21.5 times forward earnings. For long-term investors, these high valuations of tech companies are a reminder that you need to lock in profits as stocks rise. But it shouldn’t be a reason to get out of these stocks completely. First, the market is looking to the future, and in our view, we are entering a new era for all stocks. The Fed’s decision to raise interest rates in 2022 has led to a forced review of costs, making operations tougher than ever. But there is still plenty of room for further revenue growth and increased operating leverage. Therefore, we believe that the “overvaluation” we see in some of these stocks could be corrected by earnings growth in the coming years. For example, Microsoft’s valuation has fallen to about 32x calendar year 2025, while Apple’s valuation is around 31x estimated for 2025. The possibility of lower interest rates in the future can also be seen as a driver for higher valuations. Remember, the balance sheets of these companies rival nations. In other words, a premium is justified for all of these companies given their dominance, mission-critical nature and financial strength. All of this allows these companies to not only survive a high interest rate environment or economic downturn, but actually take advantage of it by investing in the future while their smaller competitors struggle to survive. Conclusion How much of a premium is justified? That’s what shapes the market. At current levels, we do not believe that the valuations we are seeing in Big Tech pose a risk of a stock crash. Rather, it is riskier to jump on and off these companies than to ride out the volatility with the understanding that revenue growth over time will drive down valuations and drive stock prices even higher in the coming years. If you don’t own Super 6 shares and want to buy, we’ve calculated the buy level for you. If you’re invested in these companies and are considering taking profits, ask yourself these three questions: 1. What are the risks? 2. What are the risks? 3. What are the risks? 4. What are the risks? 5. What are the risks? 6. What are the risks? 7. What are the risks? 8. What are the risks? 9. What are the risks? 10. What are the risks? 11. What are the risks? 12. What are the risks? 13. What are the risks? 14. What are the risks? 15. What are the risks? 16. What are the risks? 17. What are the risks? 18. What are the risks? 19. What are the risks? 20. 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The New York Stock Exchange stands in lower Manhattan on May 11, 2021, in New York City after stock prices fell worldwide on concerns that rising inflation could lead central banks to tighten monetary policy. The tech-heavy Nasdaq Composite Index was down 0.6% by mid-afternoon after falling 2.2% at a session low.
Spencer Pratt | Getty Images News | Getty Images
The warning is common — the market is driven by just a handful of giant tech stocks and is therefore resting on weaker fundamentals than a market driven by broader constituents. We think that view is lazy and misguided.
