Big Tail Risk: Investment engine of Magnificent Seven is crucial

Robert Armstrong robert.armstrong@ft.com · 1 Aug 2024

Much has been made this year of the dominance of Magnificent Seven technology stocks as a driver of the US equity market. Even after a collective share price retracement from a peak in early July, the group of Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia and Tesla still represents some 31 per cent of the S&P 500. The stocks are up a collective 31 per cent this year compared with 14.5 per cent for the S&P 500.

There is another area where the dominance of Big Tech is just as striking and more important — investment. In their last fiscal year, the Magnificent Seven had capital expenditures of $177bn or 18 per cent of the total for the S&P, according to S&P Capital IQ data. Ten years ago, the figure was just 5 per cent.

While the spending last year was down a bit, in relative terms, from the pandemic spending bonanza of 2021-22, the figure will go up significantly again this year, according to the companies themselves.

The only companies that are even remotely close to Big Tech in terms of capital spending are lower-returning businesses such as utilities, telecoms, oil companies and (to a lesser extent) auto manufacturers — plus Intel and Walmart. No one else is close.

More impressive still, the Mag 7’s share of research and development spending was 40 per cent of the S&P’s total, or $242bn, last year. This number will rise this year, too.

It should be noted that only about half of the companies in the S&P break out R&D as a separate line. But those companies are not particularly research intensive.

So if the dominance of Big Tech is overstated here, it is probably only by a little.

When you think about the massive value weighting to Big Tech within the market, the natural thought to have is: are these companies overvalued?

When you look at the rate at which they are reinvesting money, you think: who could possibly compete with them? Are they valued highly enough? Combine capex and R&D, and the Magnificent Seven reinvested $419bn last year.

If the Magnificent Seven stand above all other companies in investment, Amazon stands above the group with $53bn in capex and $86bn in R&D (what it calls “technology and infrastructure”) last year.

This is a demonstration of the company’s true superpower: sinking most of the money that it earns back into its operations, suppressing margins and fuelling long-term growth — somehow without angering investors.

This highlights the link between return on equity and valuations. If a company earns high returns on equity, more money is available to reinvest — again, at a high rate — boosting its prospects for long-term growth. Companies like the big techs that have high returns on equity should have high price to earnings valuation ratios.

There are companies in the S&P with higher ROEs than the Magnificent Seven (or rather the Magnificent Six, given Tesla does not stand out here).

But what is special about Big Tech companies is they achieve high ROEs while having an absolutely enormous amount of equity in their businesses.

Alphabet has an ROE of more than 25 per cent on equity of $300bn. That suggests immense capacity to increase investment further, as needed.

Of course, it could be that some or much of this reinvestment will not generate good returns and future growth will disappoint.

It could be, for example, that all the money being pumped into AI capacity will not find profitable applications.

This is for tech experts to speculate about. But what these companies cannot be accused of is maximising shortterm profits at the cost of investment.

There is a lot riding on this for investors in the broader market. If these companies walk back their commitments, even in the most gentle, qualified ways, the impact will immediately be felt by Nvidia and other chip stocks, which have been the other crucial support for markets. This is about as big a tail risk as investors in US stocks face right now.