Interactive Investor

Beyond big US tech, here’s where pros are finding value opportunities

Kyle Caldwell outlines areas of the US stock market where fund managers are finding much lower valuations compared with the ‘Magnificent Seven’ technology giants.

14th December 2023 11:22

Kyle Caldwell from interactive investor

Financial markets and economies are generally cyclical, with boom followed by bust. However, as the US stock market has proven over the past decade, valuations can stay rich for a prolonged period.

While fund managers investing in other regions point to low valuations, particularly when pitting a UK or European firm against a similar US-listed businesses, it takes a brave person to bet against the US.

As fund manager Schroders notes in its latest monthly analysis of valuations, non-US markets look cheaper on all the main valuation metrics, but this is nothing new.

One area that’s now carrying higher valuations compared to a year ago are the so-called Magnificent Seven tech stocks, which have seen their share prices sizzle in 2023 in response to excitement over the potential of artificial intelligence (AI) to disrupt various industries.

The seven US tech giants are becoming more influential

Year-to-date, Nvidia (NASDAQ:NVDA) leads the way with a share price return of 226%, followed by gains of 161% and 122% for Meta Platforms (NASDAQ:META) and Tesla (NASDAQ:TSLA). Next, with gains of 70%, 55%, 54% and 50% are Amazon.com Inc (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Alphabet (NASDAQ:GOOGL). Schroders says the influence of those seven firms has become so huge that they now collectively make up more of the MSCI All Country World Index than the UK, China, Japan and France combined.

While many fund managers continue to back big tech and are prepared to accept higher valuations, including Blue Whale Growth fund's Stephen Yiu, who counts Nvidia and Microsoft among his top holdings, others are hunting for value opportunities elsewhere.

Jerry Thomas, chief investment officer for global equities at Sarasin & Partners, says that while the seven US tech giants “have support from high cash-flow margins, strong balance sheets and thematic growth, augmented by the potential of generative artificial intelligence” the valuations of these stocks has “expanded dramatically”.

He adds: “The Magnificent Seven now make up nearly 30% of the S&P 500 index and have contributed almost 65% of the index’s returns for the year-to-date.”

The sectors and shares fund managers are eyeing up 

Thomas says “the environment for stock pickers looking outside the Magnificent Seven is improving”. He cites the healthcare sector as offering “an unusual number of relative value opportunities” and notes that high-quality companies, such as Thermo Fisher Scientific (NYSE:TMO) and Medtronic (NYSE:MDT), are the cheapest they've been in around five years. 

In addition, he says that some sectors are benefiting from positive knock-on effects from the pandemic. One trend, he notes, was the craze to acquire pets during lockdown. Thomas says this left companies such as Freshpet (NASDAQ:FRPT) and Colgate-Palmolive (NYSE:CL), which makes pet food as well as household, healthcare and personal care products, “scrambling to meet demand for pet food”. He adds: “Colgate is rushing to complete a new pet food facility designed to reduce costs by maximising automation”.

Fiona Harris, US equity investment specialist at JP Morgan Asset Management, says the narrowness of the rally has presented an exciting opportunity for active management, particularly those with a focus on quality”.

Harris is excited about “companies with emerging secular growth catalysts within renewables as well as grid/infrastructure modernisation”.

Healthcare was also highlighted as an area of opportunity by Harris. She says: “In healthcare, with the exception of a handful of pharma companies with blockbuster drugs, it feels like the rest of the sector continues to feel the weight of renewed political and regulatory pressures. Incrementally, we do see some good opportunities on a risk/reward basis within the space.”

Another sector that some professional investors are drawn to is real estate and infrastructure. Paul Middleton, manager of the Mirabaud Sustainable Global High Dividend fund, says: “In the US, we believe aggregate earnings estimates for 2024 are too high and need to be reset lower. More than ever, you need to be investing in those pockets of growth where estimates are supported by structural themes and where therefore, earnings estimates are more likely to be revised higher.

“One of the themes we have exposure to, which we believe will show earnings growth next year, is real estate and infrastructure. 

Smaller company opportunities

In terms of company size, US mid-cap and small-cap stocks offer lower valuations than their larger company peers.

Rupert Rucker, investment director, Schroder US small and mid-cap equities, points out that smaller, more domestically oriented companies in the US are often better positioned to benefit from changing trends in the US economy.

He adds: “Retaining exposure to US equities remains an important allocation in a diversified investment portfolio, but there are reasons to reconsider allocations across the asset class. Over much of the last decade, investing exclusively in the S&P 500 would have been the best decision. However, change is now under way. There are now good reasons for investors to broaden their allocations into small- and mid-cap US companies that are more attractively valued and better positioned for a changing market environment.”

The case for an equally weighted approach

For investors who prefer to passively invest in the US market – through an index fund or exchange-traded fund (ETF) – the dominance of the seven technology companies in 2023 may strengthen the case for an equally weighted ETF rather than the more common market-cap weighted approach.

Risk is spread far and wide with an equal-weighted index, which holds each company in equal proportion. For example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

One of the main benefits is that an equal-weighted ETF avoids being overexposed to stocks that have become overvalued or, worse still, potentially part of a bubble.

Another plus point is that an equal-weighted index offers more exposure to parts of the market that have performed less well in recent years. Going forward, if there’s a broader set of winners in US markets, this approach will in theory capitalise on that more than market-cap weighted indices.  

The trouble is there’s much less choice in terms of index funds and ETFs tracking an equal-weighted index. Examples on interactive investor include the Invesco S&P 500 Equal Weight ETF, and Invesco NASDAQ-100 Equal Weight ETF.

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