The so-called Magnificent Seven tech stocks have dominated market returns in recent years, but investors would be wise to broaden their horizons and look for other companies benefitting from innovation.
What do Wang Laboratories, Palm, Kodak, Nokia, Compaq, Friends Reunited, and Blackberry all have in common? That's right, they all lost their dominant market positions when they missed an important sea change in their industry.
Working through the dotcom boom of 1999 we well remember when companies like Cisco and Intel could do no wrong. They were the unquestioned Kings of the Internet – until they weren't.
The parallels with the current enthusiasm towards the so-called Magnificent Seven largest US technology stocks are evident, and while they are unquestionably riding high in their respective industries, we mustn't forget that all companies have inherent fragilities, which tend to be overlooked when things are going well.
Concentration risk
This becomes an issue when markets are as concentrated as they are today, with the group accounting for around two-thirds of the performance of the S&P 500 index in 2023, and almost half so far this year. Although the trend is improving, given their dominant size at now 30 per cent of the S&P index, they still have a significant gravitational pull. In fact, the index has not seen such concentration at the top since 1960 (incidentally when the original Magnificent Seven movie was released). Despite recent performance, most of the companies in this group do not appear vastly over-valued, but as always with investing, it’s a question of risk and reward. If this small group do keep outperforming, they could soon enter the territory of the financial bubble. Not a place to be invested if sentiment changes.
Consider Nvidia, the leader of the pack (in performance not size) and globally dominant in graphics processing units (GPUs), now the keys to the kingdom for generative AI. Through a combination of judgement and good fortune Nvidia found itself at the centre of three waves of innovation over the past decade — firstly with gaming, for which GPUs were originally designed, then crypto mining, and now generative AI. Both previous trends drove the shares up dramatically only to give back much of the performance when the supply/demand dynamics normalised. Time will tell if history rhymes again for AI, but there are plausible reasons why it might.
Life in the cloud
The three giants of cloud computing, Amazon (through its AWS division), Alphabet, and Microsoft bet big on cloud, invested aggressively and now lead the world in cloud computing as a service. Their investment is now paying off as more companies transition their data and computational workloads on to these huge cloud servers. They are now betting on a similar trend for AI and are the largest customers for Nvidia’s AI GPUs, paying a very high price for the privilege. This arms race is unlikely to persist at the current rate for long, and when the dust settles, they must find profitable business models to get an acceptable return on their investment.
The market is betting they will, and while their track record counts on their side the outcome remains unclear.
Google’s business model relies on answering user queries by a set of web links, some of which are paid-for search advertising. If its Gemini AI chatbot simply gives you the answer as paragraphs of text, then that revenue source will be disrupted.
If we step away from the limelight and look at other beneficiaries of AI, we find businesses with strong growth potential where the risk-reward trade off might look more attractive. Take high bandwidth memory for example. AI data centres need an enormous quantity of these expensive semiconductors and the industry that makes them is a disciplined, concentrated group of three companies. SK Hynix was the first mover in this segment, but there are good reasons to look at Micron or Samsung as well.
New challengers from China are threatening the previously unassailable positions of Amazon and Tesla. Have you bought anything from Temu yet? They are just beginning. On the electric vehicle (EV) side BYD, Nio and Xpeng, are changing the competitive landscape for Tesla by producing impressive vehicles at highly competitive prices. In this industry it may be less risky to invest in segments that don’t have the same binary risks of success. For example, EVs use five times as many power semiconductors as traditional engine cars, and again there are only a small number of companies producing them. As suppliers to multiple manufacturers, they are less dependent on the success of any one vehicle brand. Infineon in Germany leads the industry, but Onsemi, or STMicroelectronics, are also worth a look.
The lure of automation
Looking away from the AI juggernaut, Amazon's core business in retail is also innovating quickly. As it fills up the logistics capacity built in the Covid era and looks to expand, it is turning more and more to automation and robotics technologies. The reasons are obvious when one considers the costs of finding training and retaining staff in an increasingly competitive, and expensive, jobs market. We see attractive investment opportunities in this space, such as Zebra, the US maker of logistics automation equipment, or Autostore in Norway, building some of the most efficient and space saving storage and retrieval systems on the planet.
The beneficiaries of innovation are not always the most well-known companies and at a time when everyone is focused on one small group it might be time to look up and broaden your investment horizons.
Graeme Bencke, fund manager, Amati Global Innovation Fund
