Yes, investors should diversify in a risk-controlled manner, as mega-cap tech stocks have delivered exceptional fundamentals but are expensive and represent an outsized share of the equity markets. Investors should diversify concentration risk by leaning into more attractively valued segments of the market, namely developed markets small-cap and value stocks.
Over the last 15 years, US equities have accounted for 58% of developed markets equity returns, with roughly half of the US return attributable to the tech and interactive media sectors, according to analysis by Empirical Research Partners. In recent years, returns have been driven by tech stocks’ earnings strength, particularly Nvidia and most of the Magnificent 7 (Mag 7). In fact, if you exclude the Mag 7, earnings growth for US stocks has lagged that of other developed markets, although US stocks are expected to catch up again in the next year or two. While earnings growth for the Mag 7 has been exceptional, the scale of capex and research and development (R&D) spending by these firms on artificial intelligence (AI) initiatives have raised doubts about the ability of AI applications to deliver a return on investment that can support continued elevated earnings growth.
Investors are right to be concerned. While disruptive innovation cycles create vast opportunities, their scope and timing are difficult to estimate. During the technology and telecommunications boom, real capital expenditures increased at a rate of 12% per year from 1991 to 2000. As much as 95% of installed fiber-optic cable remained unused immediately following the bursting of the technology, media, and telecom (TMT) bubble, which forced overleveraged telecommunications out of business. AI spending has been significant, with Mag 7 capex and R&D spending totaling $419 billion in 2023, accounting for about 20% of S&P 500 capex and 40% of reported R&D with more expected in the next few years.
However, there are important differences between the TMT bubble and the current AI buildout. In contrast to the overleveraged telecommunications firms of the TMT bust, most of the Mag 7 benefit from high free cash flow margins and squeaky-clean balance sheets. At the height of the tech bubble, TMT stocks were spending more than 100% of operating cash flows on capex and R&D. In contrast, today’s mega-cap tech companies’ capex and R&D as a share of cash from operations is 72%, close to the 40-year median of 67%. Should development of profitable applications using AI disappoint, high valuations will not be sustained.
Mega-cap tech stocks, particularly the Mag 7, are central to the broad market’s performance, as they account for about 20% of global equities and 30% of the S&P 500 market capitalization. The concentration and level of valuation warrants tilting away from these names. Historic performance data studied by Petajisto revealed that the top quintile of stocks by performance in the US equity market over a five-year period subsequently underperformed the broad US equity market over the next ten years. This underperformance was consistent and meaningful. The median of prior stars underperformed in nearly 86% of monthly rolling periods since 1926 by a cumulative 17.8% over the decade, or nearly 2 percentage points per year. Yet, the strength and growth prospects of this set of mega-cap tech companies drive us to diversify away in a tightly risk-managed fashion, tilting modestly into more attractively valued segments of the market.
Many portfolios already have sufficient underweights to large-cap equities relative to market benchmarks, given the use of active managers. Active managers tend to both differentiate bets within Mag 7 names and hold more equal-weighted portfolios. While non-US equities offer cheaper valuations than US equities, US equity valuations are less elevated once we exclude the Mag 7. We expect tilting toward value and small caps in developed markets will add more value to portfolios than overweighting non-US developed markets. Within small caps, we focus on higher quality, particularly in the US market where a greater share of small caps has no—or negative—earnings.
Celia Dallas, Chief Investment Strategist
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