Nvidia published another barn-storming set of results last week, with third quarter revenue up 94% to $35.1bn. The share price dropped 4%, in what has become a familiar pattern for Nvidia in the wake of its results. It has once again raised the problem of expectations, and whether they are now so high that the dominance of the magnificent seven story might finally draw to a close in 2025.
The results showed a 112% uplift in data centre sales, which appears to demonstrate that the AI trend is real and building momentum. All divisions were in positive territory, with underlying operating profit and cash flow rising strongly. The company now has net cash of $30.2bn. However, gross margin dropped a little and the company’s price-to-earnings ratio remains at its highest point in a year.
Elsewhere for the mega caps, the picture is mixed. At one end, Elon Musk’s proximity to the new administration appears to be paying off. Tesla’s share price has leapt, as President-elect Donald Trump announced support for self-driving cars. However, there are potential problems for Apple. Warren Buffett has been a high-profile seller of the shares, dumping $14.34bn worth of Apple shares in the third quarter of 2024. Apple also faces potential challenges on tariffs.
Many investors are highly exposed to the fortunes of these mega caps and their trajectory is consequential. As a group, they have delivered returns of 53.6% over the year (CNBC Magnificent 7 index, to 22 November), even if the individual fortunes of the companies have been mixed.
Johanna Kyrklund, group head of multi-asset investment at Schroders, said: “The magnificent seven was very much a story for 2023. This year it’s been a bit dented. But the peak in that story was in June/July. When we look at the numbers, compared to the internet bubble we had in the late 1990s, they are delivering very strong earnings. The question is how much is baked in in terms of expectations. There are plenty of earnings there, which was not the case during the internet bubble.
“They could continue to rise, but it’s really a case of looking for other opportunities. For example, this year, US utilities has been a very attractive sector. No one talks about that. There’s actually quite a lot of opportunity under the surface that people are missing because of the obsession with the mag seven. I wouldn’t be betting against them, but there are better opportunities elsewhere.”
AI support
In their favour, the Magnificent Seven remain the most obvious way to tap into the AI trend. Richard de Lisle, manager of the VT de Lisle America fund, said: “We have seen this historically: something causes a catalyst, then people become hopeful about the wonderful things that might be coming in the future. The valuations get somewhat suspended.
“It doesn’t matter how much Apple increases their revenues, because it’s the promise of what AI will do for the phone market. It’s been one of these years where there’s a general feeling that our lifestyles are going to change, and more quickly than they have before.”
However, while few dispute that artificial intelligence is likely to be every bit as important as the internet. The question is whether these companies are the best way to play the next wave of AI.
Nils Rode, chief investment officer for private markets at Schroders Capital, points out that most of the innovation in AI is taking place in venture-backed start-ups. He said: “If you look at pure-play AI companies, nearly all of them are private companies…there are hundreds of start-ups that are working to bring AI to consumers in a way that is useful and to help enterprise implement AI and change their processes, which is not easy.”
De Lisle agreed that there are other ways to play the trend. He has invested in a company that creates data centres, and another one that improves the efficiency of the power supply. This is a way to get exposure to AI without having to pay too much for it.
Mega-cap growth
There is also a question of the dominance of passive investments. There are few signs of this slowing, in the UK market at least. In the latest IA statistics, overall net retail sales were down £3.4bn ($4.26bn), yet tracker funds saw £1.7bn in inflows. In the previous month, tracker funds again propped up the industry, with £2.5bn in inflows, compared with just £806m overall. The rise and rise of passive funds has helped cement this trend towards mega-caps
Simon Evan-Cook, manager of the VT Downing Fox Funds, said: “The trend of the past 10 years has been mega-cap growth, but the mega cap is more important than the growth. When you look across all markets, if you look at what unites market leadership, and where money is moving to, it’s in some way or other, mega caps. That is the big worry because valuations are high.”
When a trend goes on for so long, it will suck everything towards it. This was seen historically with the commodities supercycle. Ultimately it peaked and collapsed under its own weight, and the companies involved underperformed for a decade.
“Without knowing it, advisers are potentially having all their investments sucked towards mega caps,” Evan-Cook added. He said this has even been the case in the value world.
Is there a point where this is self-limiting and the price discovery mechanism in markets no longer works? De Lisle pointed out that this question was put to Jack Bogle, founder of Vanguard and passive investing pioneer.
He said: “Will passive investing ultimately fail because it’s an inefficient allocator of capital? Bogle said it would fail at around 75%, but he says that was only because it ‘felt right’ rather than having any real science behind it”. These numbers are now beginning to come into view, with passive funds now more than 50% of the US mutual fund industry (source: Morningstar).
This vogue for passive could continue to support the Magnificent Seven, or its latest iteration for some time, even if the fundamentals look increasingly unattractive. The problem is that the end, when it arrives, could be swift and painful as the momentum that supports the mega caps reverses.
This story first appeared on our sister publication, PA Adviser.
