One of the most notable features of the stock market in recent years has been the success of large US technology companies. Their performance has been so stellar that commentators have grouped them together under labels such as the “FAANGs,” the “Tech Giants” and, more recently, the “Magnificent 7” or “Super-7” (Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Tesla).
And 2023 is shaping up to be yet another strong year for these companies. This is due, in part, to the impact of generative AI (artificial intelligence). The launch of ChatGPT in November 2022, a generative AI model that provides credible answers to almost any language-based question, has created renewed enthusiasm for companies seen as AI winners.
Semiconductor designer Nvidia, for example, has seen its stock price rise by more than 200% year-to-date. Given moves like this, many investors may question whether the future can be anything like as bright. We believe that there are reasons to think so.
Investors need to look beyond the Super-7 grouping and consider each stock individually
Before delving into the detail, it is important to draw out some key observations. The first is that the major drawback of monikers such as the Super-7 is that they create a false sense of similarity. While there is some overlap (for example the rivalry in cloud services between Amazon, Google (Alphabet), and Microsoft, there are also enormous differences between them.
The market dynamic within enterprise software (Microsoft) is vastly different to that of electric vehicles (Tesla), smartphones (Apple) or social media (Meta/Facebook). It is easy to overlook company nuances when using blanket classifications. As such, investors need to look beyond the Super-7 grouping and consider each company individually.
High market capitalisation can be justified by large fundamentals
The second point is that it is important to remember that large market capitalisation can be justified by large fundamentals. This might sound obvious, but these companies are some of the most profitable and cashflow generative in the world. For that reason, they command higher-than-average valuations in the stock market.
Finally, attributing all the performance of these stocks to the excitement around generative AI does them a disservice. While generative AI has and will be a significant tailwind for some of these businesses (as with Nvidia), their strength in 2023 cannot be attributed solely to AI. We only need to look at Meta/Google to illustrate this – both companies are likely to deploy generative AI aggressively in the coming years, but the shares have been supported by the combination of recovering end markets and cost optimisations. This has led to significant improvements in profitability and cash flow, particularly at Meta.
Cloud transition offers huge growth opportunity
Cloud computing will remain a powerful trend for many years to come. Even though there has been a slight moderation in cloud spending in recent months, the benefits of outsourcing data storage and management, in terms of cost, flexibility, and security, mean that businesses will continue to migrate to the cloud for the foreseeable future. According to an estimate by Amazon in April, 90% of global IT spending is still on locally run, company-owned hardware, known as “on-premises” solutions.
There is a huge growth opportunity for companies with the funding and technical capability to provide the necessary infrastructure for this transition. Unsurprisingly, the largest technology groups are the dominant providers of cloud services through their subsidiaries AWS (Amazon), Azure (Microsoft), and GCP (Google). And they are likely to continue to lead the market.
In addition to their cloud businesses, Microsoft, Amazon, and Google each have other significant growth opportunities. Microsoft’s suite of enterprise software products is widely used by companies of all sizes around the world. The growth of these is likely to be boosted by the rollout of generative AI enhancements, such as Microsoft Co-pilot for Office.
Amazon has a dominant e-commerce business that is currently under-monetised but should demonstrate improving profitability as the significant investments made in recent years are amortised.
Google has a strong position through both Google Search and YouTube and is likely to continue to innovate and provide increasingly effective advertising services to customers. The combination of cloud assets and adjacent businesses means that Microsoft, Amazon, and Google will continue to grow at respectable rates for the foreseeable future. Elsewhere, Meta faces the challenge of running a global social media business in a turbulent world, as well as lingering concerns about the company’s governance structure, specifically Mark Zuckerberg’s control of the company. However, Meta has undertaken prudent investments and product innovations over the past two years. The company has adapted to privacy changes in the advertising market, successfully competed against emerging rivals such as TikTok, and strengthened customer engagement through platforms such as Instagram and WhatsApp.
The remaining constituents of the Super-7, Apple, Tesla, and Nvidia face a variety of different challenges. Apple is an extraordinary company that continues to offer some of the best consumer products in the world. However, its end markets are maturing, particularly in smartphones where penetration rates are high worldwide. There is also the ever-present risk of innovation in wireless technology. On the other hand, Apple generates massive cash flow, much of which is returned to shareholders through buybacks. Additionally, the company invests substantial amounts in its growing and highly profitable services business, which includes the App Store, Apple Pay, Apple Music and TV, Apple News, and Apple Care.
Tesla led the creation of the electric vehicle (EV) industry and has significant competitive advantages due to its scale, market-leading manufacturing processes, and software solutions. However, it may be vulnerable to price pressure as competition in the EV industry intensifies.
Nvidia is a key enabler of the rollout of generative AI worldwide. The company’s GPUs (graphics processing units) are best-in-class products capable of handling the complex calculations required by large language models that power generative AI applications. After an extraordinary acceleration, revenue is expected to double year-on-year in 2023. However, the sustainability of the company’s growth profile is uncertain. In the short term, a scenario of excess capacity is entirely plausible, especially as key customers, such as hyperscaler vendors, have been volatile spenders in the past.
Overall, while it may be tempting to move on from the Super-7 after such a strong year, we believe a more nuanced approach is the right one. The group is heterogeneous but united by the common denominator of strong business franchises in growing areas.
As ever with equities, investors need to remember that price is what you pay; the key question is whether value is what you get.
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Issued in November 2023 by Schroders Investment Management Ltd registration number: 01893220 (Incorporated in England and Wales) which is authorised and regulated in the UK by the Financial Conduct Authority and an authorised financial services provider in South Africa FSP No: 48998