AI, the ‘Magnificent Seven’ and other musings

“If you’re not a little confused by what’s going on, you don’t understand it” – Charlie Munger

It’s one of my favourite quotes. And right now, it seems pertinent. 

Momentum reigns. Broadly speaking, the winners keep winning, the biggest companies keep getting bigger, and the same themes – especially Artificial Intelligence (AI) – continue to dominate investor sentiment. 

Why is this happening? What does it mean? And how might investors position themselves in response?

Winners keep winning

The performance of the ‘Magnificent Seven’ technology companies – Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta and Tesla – has been remarkable.

After a difficult 2022, they have bounced back with a vengeance, rising by over 200% on average. Chip maker Nvidia has led the rally, up an astonishing 700% since the start of 2023 and 136% since the turn of this year. Past performance is not a guide to the future. 

Nvidia share performance over last 5 years (%)

Artificial intelligence (AI) driving gains

There are several reasons these tech behemoths are performing well, ranging from their dominant market positions, highly cash-generative business models and growing economic confidence. 

However, the biggest source of gains – especially for Nvidia, Microsoft, Amazon and Alphabet – probably relates to excitement around AI. 

Since the launch of ChatGPT (November 2022), a raft of companies across almost every industry have rushed to integrate Generative AI into their products and services. 

Nvidia has been the biggest beneficiary. In the year to 28 January 2024, revenues more than doubled and operating profit more than tripled, on the back of growing demand for its AI chips. 

Nvidia has become the undisputed leader in producing chips that can perform complex AI tasks. As long as companies keep pouring more money into developing AI solutions, Nvidia should stand to benefit. And right now, there is seemingly no one that can credibly compete with it.

The public cloud providers – Microsoft, Amazon and Alphabet – have also benefitted from the AI rush. 

These provide businesses with the infrastructure and services they need to quickly develop, deploy, and scale AI applications, without incurring significant upfront investments themselves. As such, growing demand for AI solutions is seen as a multi-year growth tailwind for the public cloud giants.

The launch of new AI products and services is another potential growth driver. In theory, this opportunity extends to any business. But the big tech giants - given their size, scale and dominance - are considered especially well placed.

Is the AI ‘hype’ justified?

The short answer is – I don’t know. 

I can see good reasons why AI will continue to gain traction.

In particular, it could prove transformative in automating relatively complex but labour-intensive tasks – like coding, data crunching and summarising documents. I can also envision how many companies could incorporate AI to augment existing solutions, from software to online search tools, to increase revenues, lower costs or improve the customer experience. 

However, at this stage no one really knows how embedded AI will become in our everyday lives. It could take longer – or be less impactful – than expected. Time will tell.

Where does this leave the ‘Magnificent Seven’?

If demand for AI products and services accelerates, the US tech giants look well placed to benefit.

However, there are risks, even beyond the speed and scale of the AI roll-out. Arguably the biggest relates to capital spending. 

Big Tech companies are investing significantly in laying the groundwork for the AI revolution. The combined capital expenditure at Microsoft, Alphabet and Meta is set to grow around 50% in 2024, to over $130 billion.

Capital expenditure ($ Billions)

In truth they have little other choice – failure to invest could allow competitors to eat their lunch.

However, it means they are much more capital intensive than they used to be. This isn’t necessarily a problem, so long as this spending generates strong returns. But if it doesn’t, margins and cash flows could come under pressure.   

With regards to Nvidia, it is very dependent on the capital expenditure of these big tech companies, so their fortunes are inextricably linked. Longer term, there are also question marks over whether Nvidia can maintain its lead as competitors scramble to catch up; a risk I find difficult to frame at this stage.

History should encourage caution

Historically, ‘transformative’ technological changes have proven much more a risk than an opportunity for investors.  

In the late 1990s technology bubble, the internet was seen as a game changer, and so it proved. But picking winners was like trying to find a needle in a haystack. And most internet-based companies failed: Amazon was very much the exception.

The same happened with cars and planes. Both industries seemingly had hugely exciting futures that caused investors to drool. Both were transformative to global economic prospects and society. But both caused untold destruction of shareholder value. Of the thousands of car companies and hundreds of airlines that once existed, only a handful still stand.

Could the ‘Magnificent Seven’ suffer the same fate? It’s possible, though probably unlikely in my view. 

They have superb business models, excellent competitive positions and are enormously profitable, while valuations – although high – do not appear egregious. The same could not be said for perceived tech ‘winners’ in the late 1990s.

However, I am mindful that history doesn’t repeat but it often rhymes. 

Exciting and ‘transformative’ growth trends nearly always see an explosion of competition. The ‘Magnificent Seven’ will need to fight tooth and nail to ensure the ‘AI winner’ label sticks, or risk seeing their competitive positions eroded. 

As for ‘AI winners’ outside of this select group - I think most will prove anything but. In fact, I’m convinced there will be many more ‘AI losers’ than ‘AI winners’, just like every technological revolution in the past.

How I’m positioning my portfolio

I do not invest based on themes, trends or momentum. And I have no intention of jumping on the AI bandwagon. However, I am not ignoring AI’s enormous potential. 

Several companies in the Quality Shares Portfolio stand to benefit if AI gains traction, including Microsoft and RELX (which I discussed in my previous article). But in each case, I see AI as a potential cherry on top of a very formidable cake, layered with multiple competitive advantages – not the sole reason to own the company.

Currently, Microsoft is the only ‘Magnificent Seven’ company in the portfolio. This is due to the diversity, strength and dominance of its business model, which has enabled it to adapt to changing technological trends over many decades.

I would not rule out adding another to the portfolio. But this decision will be driven by my assessment of the company’s long-term prospects, durability and resilience – not by a desire to align more closely to the benchmark or by short-term considerations (like hoping to ‘catch’ momentum trends). And certainly not because other investors have labelled the company ‘Magnificent’.

Finally, given the seemingly unstoppable progress of the ‘Magnificent Seven’ and their increasing significance in indexes and benchmarks (c.35% of S&P 500), it might be tempting to overlook the merits of diversification. I have no intention of doing so.

I aim for every company in the Quality Shares Portfolio to offer something different. Filling my portfolio with Big Tech (which increasingly overlap and are aligned to the AI theme) would be at odds with that. Besides, investors can easily access these via a low-cost tracker.

A time for humility

The ‘Magnificent 7’ are formidable businesses and I wouldn’t be surprised to see them continue to perform well. However, I don’t think now is the time to go chasing after them.

AI presents great opportunities for these companies, but also potential risks. Not least the huge capital expenditures required to lay the groundwork. This could lead to a supply-demand imbalance, if not now then at some point in the next few years. History urges further caution, suggesting ‘AI losers’ will outnumber winners many times over.

I think now – more than ever – it’s a time for humility. 

No one knows how this AI revolution will play out, nor whether the ‘Magnificent 7’ will enjoy most of the spoils. However, I’m convinced there are some brilliant companies outside this small group with exposure to exciting and diverse growth themes (of which AI is just one).

I continue to believe a carefully selected portfolio of such businesses could stand investors in good stead and serve as a valuable portfolio diversifier.