We start with a quick quiz question: What movie plot involved poor farmers seeking protection for their village from oppressive bandits?
Time’s up. Answer: Seven Samurai (1954).
However, since we are thinking about the U.S. stock market, there is another answer: The Magnificent Seven (the 1960 version, that is, starring Yul Brynner, Steve McQueen and Charles Bronson, and not the 2016 remake.)
Of course, the “Mag 7” refers to the seven largest growth companies across three sectors: Apple, NVIDIA and Microsoft (Tech), Alphabet and Meta Platforms (Communication), and Amazon and Tesla (Consumer Cyclical). Together, these seven stocks have almost single-handedly propelled the S&P 500 Index to a double-digit year-to-date increase.
Their individual performance this year (through November 14) is eye-popping:
For the first ten months of 2023, the S&P 500 Index was up 10.7%. The Mag 7 contributed 10.8%, which means that the remaining “Undistinguished 493” stocks in the Index collectively contributed a slight negative return. The median stock return for the “U-493” stocks was -2.25%. 274 stocks in the Index had negative returns through October, while another 81 returned less than 10%. October also saw 155 companies (plus another 55 in November so far) hit their 52-week low stock price.
The following chart compares YTD performance through November 14th for the traditional market capitalization-weighted S&P 500 Index (+18.8%) and the equal-weighted version of the Index (+2.1%). It is readily apparent that the U-493 have struggled this year.
The Mag 7, of course, is reminiscent of another similarly used acronym of yesteryear, the “FANG” stocks (Facebook (now Meta), Amazon, Netflix and Google (now Alphabet)), first coined in 2013 (another “A” was added for Apple in 2017 to create “FAANG”). Investors use these acronyms around the notion that the stocks of just a few large companies have a disproportionate influence on the performance of the stock market as a whole. This sentiment is often expressed as a surprising thing, such as “The FAANGs bailed out the market again this year.”
But should this be a surprise to us? Cliff Asness, co-founder of the quantitative investment firm AQR, wrote an article on this phenomenon in January, 2015, cleverly entitled “SNAFU: Situation Normal, All-FANGed Up.” Asness calculated the impact on calendar year returns on the S&P 500 of removing the top contributing stocks for the period 1995-2014. It turns out that the top 10 stocks contribute on average 4.1% to the annual S&P 500 returns, and the top 20 contribute 6.3%.
So, it should not be surprising that the largest stocks in a cap-weighted index should drive overall index returns. It tends to happen every year. It so happens that this year is something of an outlier, similar to the Tech Bubble in the late 1990’s, when, for example in 1999, the top 10 contributors added 11% to Index returns that year.
Does this mean that the optimal investment strategy is to simply buy the largest, most popular stocks? A recent research piece from Dimensional Fund Advisors, “Think Twice about Chasing the Biggest Stocks”, helps to answer this question, looking at market data back to 1927. They write “As companies grow to become some of the largest in the US stock market, their returns can be impressive. But not long after joining the Top 10 largest by market cap, these stocks, on average, have lagged behind the market.”
This is illustrated in the chart below:
The article concludes by summarizing:
An interesting perspective on all this comes from research published on the topic of investing in popular stocks, defined as “brand name stocks in the news.” In a 2014 paper, the authors describe “Investors who are overly confident may go after the most popular stocks and end up driving the price too high, as seen in the Internet [Tech] Bubble…Herding is also a behavioral theory, and of course popularity and herding are similar concepts.” They studied the returns of popular stocks versus less popular stocks for the period 1972-2013.
Their conclusion? Less popular stocks outperform more popular stocks (with less volatility) over long time periods:
In the end, stock investing comes down to valuation: What price are you willing to pay for a share of common stock. The largest companies got that way because they had good management, good products and services in good markets. They often grew very fast over a relatively short time period, creating significant wealth for their owners.
The problem for investors is not necessarily finding good companies, but finding good companies whose shares are reasonably priced. Here are the current Price/Earnings and Price/Sales for the Mag 7 stocks, showing very high valuation metrics:
The bottom line for investors in individual stocks: (1) Beware of your own behavioral biases, such as overconfidence and herding, which the Fear-Of-Missing-Out may trigger; (2) If you owned any of the Mag 7 this year, congratulations! But if you are still thinking about owning them, remember that the Mag 7 performance you saw in the chart above all went to somebody else, and that past performance is no guarantee of future results; (3) Stay focused on valuations. Good companies do not always make good investments.
In years to come, there will no doubt be other Mag 7 stocks “riding into town to save” the stock market. Will you be able to identify them years in advance? If not, a well-diversified portfolio is a good antidote to FOMO, and it just may help you sleep better.
All information is from sources deemed reliable, but no warranty is made to its accuracy or completeness. This material is being provided for informational or educational purposes only, and does not take into account the investment objectives or financial situation of any client or prospective client. The information is not intended as investment advice, and is not a recommendation to buy, sell, or invest in any particular investment or market segment. Those seeking information regarding their particular investment needs should contact a financial professional. Coyle, our employees, or our clients, may or may not be invested in any individual securities or market segments discussed in this material. The opinions expressed were current as of the date of posting but are subject to change without notice due to market, political, or economic conditions. All investments involve risk, including loss of principal. Past performance is not a guarantee of future results.
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