Excitement around artificial intelligence and a resilient US economy has driven tech stocks ever-higher this year. So much so that the so-called 'Magnificent Seven', which includes Alphabet (US:GOOGL), Amazon (US:AMZN), Apple (US:AAPL), Meta Platforms (US:META), Microsoft (US:MSFT), Nvidia (US:NVDA) and Tesla (US:TSLA), now make up almost a third of the S&P 500 by value, up from a tenth a decade ago.
This offers an opportunity to find bargains in the smaller stocks that look increasingly cheap and that could also insulate investors from a turnaround in Magnificent Seven fortunes. “These lofty valuations may not be sustainable, as a potentially moderating economy and rapid monetary tightening leave corporate profits increasingly vulnerable,” said Dan Skelly at Morgan Stanley.
The Magnificent Seven are currently trading at an average price/earnings (PE) ratio of 41. This is well ahead of the wider S&P 500, which is trading on 18 times its forward earnings, down from 20 times in the middle of the summer. On an equal weighted basis, the S&P 500’s PE ratio is around 15.
“As the market has become more concentrated, there are a lot of businesses that were out of our remit a few years ago that have now come into our range,” Robert Lancastle, JO Hambro’s Global Opportunities fund manager, told the Investors’ Chronicle.
JO Hambro's global fund has long been weighted away from the US because of the high valuations. However, it is now taking more exposure as valuations come down. “We have nearly 60 per cent in the US now, whereas before it was more like 40 per cent,” said Lancastle.
A screen of S&P 500 companies with good earnings growth and weaker share prices throws up some usual suspects – Tesla is on top thanks to its 205 per cent climb in earnings per share in the past two years – but there are some options a UK investor may not have come across. Dublin-based automotive technology supplier Aptiv (US:APTV) rates highly due to consistent earnings growth and a poor share price performance this year. Analysts see its EPS growth continuing as well, and have increased forward EPS forecasts by 25 per cent over the past year. Enphase Energy (US:ENPH), a rooftop solar and storage specialist, has seen its share price tumble 70 per cent this year even with earnings largely holding up. Its Q4 sales are set to be almost half that of Q2, however, so the market may have this one right.
JO Hambro has picked dental software company Henry Schein (US:HSIC) and logistics business GXO Logistics (US:GXO) as value targets. In February, they were valued at 17 times and 22 times their earnings respectively, but these ratings have now fallen to 11 times and 17 times, despite no significant drop-off in operating profit at either.
In fact, in the three months to September, GXO saw its revenue rise 8 per cent year on year to $2.5bn (£2bn), and it has also signed $841mn of new business in the year to date. Despite beating earnings expectations, the stock is still well below its summer peak. "We think GXO's resilient model is on full display here, seeing resilient profit margin and cash flow,” said Jefferies analyst Stephanie Moore.
The Inflation Reduction Act stimulus package by the US government means there is also money flowing towards infrastructure and construction projects. In particular, the government has earmarked billions of dollars to fund semiconductor manufacturing and renewable energy projects. “JO Hambro has not invested in US infrastructure for ages but [the country] can’t rely on one square kilometre in Taiwan for their semiconductors any more,” explained Lancastle.
For this reason, JO Hambro’s fund is invested in building materials company CRH (US:CRH), which recently relocated its listing to the US. The Irish headquartered company makes around 75 per cent of its profits in the US and is currently trading on just 12 times its forward earnings. “CRH has massive cash flows, not much debt and it is government money that is coming to them,” said Lancastle.
When the market is highly concentrated it is hard for fund managers to justify their fees, especially when it is seven of the most famous companies in the world that are outperforming. This is why retail investors have outperformed the S&P 500 over the past three years, according to Vanda Research.
With value now appearing in the rest of the market, there is an opportunity for fund managers, alongside any investors willing to be diligent with their research, to find value. The fear of a recession caused by increased rates does lie on the horizon, but in the long term it is usually a bad idea to bet against the US economy.
