My Grandad was into horse racing, it was his passion. If you named a horse, he could tell you who its sire and dam were and when he bet it was always “on the nose”. There were no ‘each way’ bets for him! As a youngster I didn’t understand how the same horse didn’t win all the time – surely if it was the fastest once then it would nearly always be the fastest. That was when he explained the handicap system to me – every time a horse won it would carry a heavier weight in its next race. This is what made it interesting, uncertain, unpredictable and his passion in life.
Serial winners – despite their valuation handicap
In the stock market the handicap system is provided by valuation. Yet in the period since the global financial crisis (GFC), it has seemed as though the valuation handicap has not evened out the race. Year after year the same winners have emerged despite being accorded ever higher starting valuations. The consistent winners have been the US equity market, within that the technology sector and within technology the names that have become known as mega cap tech, the MAG 7 or most recently as Broadcom became the eighth stock to top $1 trillion in market cap – BATMMAAN (Broadcom, Apple, Tesla, Microsoft, Meta, Alphabet, Amazon and Nvidia). Astoundingly these eight names now account for over 23% of MSCI ACWI market cap.
To put that scale in context the entire Japanese market is 4.7% of MSCI ACWI and the UK market just 3.0%. For years we have been hearing from asset allocators that the UK equity market is cheap, but it has consistently underperformed. The weight on the horse that was the UK equity market was not low enough for it to be competitive. Indeed, at times it seemed that you could take the jockey off its back, and it still wouldn’t have kept up with the US market.
Figure 1: UK equities underperform US dominated rest of the world
Source: Bloomberg, FTSE All-Share relative to MSCI World (price series)
“Why have consistent winners emerged? The answer is the strength of their fundamentals.”
So, what has gone so wrong with the stock market’s handicap system, why has valuation failed to even up the race and why have consistent winners emerged? The answer is the strength of the fundamentals of those US technology names mentioned earlier. Since IPO in 2004 (we bought it here in 2005 and have held it consistently ever since) Alphabet has compounded revenues and earnings in excess of 25% per annum – for twenty years! That is almost unparalleled in terms of scale and certainly duration. Amazon have grown revenues by 25% per annum over the same twenty-year period, Meta only came to market in 2012 but they have compounded revenues at 35% per annum since then. Apple has grown to dominate the profitability of the mobile phone market, while buying back 42% of their outstanding stock since the end of 2012. Nvidia have been the most explosive, revenues of $27bn in the company’s fiscal year 2023 (a January year-end) are set to be close to $130bn just two years later. In the last twenty years, in the UK, the FTSE All-Share has grown earnings by 3.4% per annum and that growth rate slowed after the GFC. Now you can see why the handicap system failed. Even the team at Paddy Power could not have set the starting odds at the right level in this race. It was without precedent and an impossible task.
This is history. It says nothing of the future, but it does help set the starting odds, the valuations of the runners and riders. The forward price/earnings (PE) multiple on the S&P 500 is 22x versus the average 13x on the rest of the world. The average PE for BATMMAAN is 29x. I exclude Tesla from this as I personally don’t consider Tesla to be a magnificent business.
Can the pack close the gap?
Today it seems that virtually everyone has a smart phone, and the movement of advertising on-line has already substantially occurred. The growth rates of these businesses going forward will be more pedestrian than they have been in the past twenty years, but the cash generation and capital allocation possibilities remain robust. They remain powerful quality franchises. Apple will likely generate over $100bn of free cash flow this year. However, cloud computing is a fast-growing oligopoly and AI is nascent. As a group BATMMAAN is unlikely to match the growth rates or the duration of growth they have historically but they are still set to be very competitive. Collectively they are spending over $200bn on capital expenditure and close to $260bn on research and development. Should this generate anywhere close to the competitive advantage and product optionality it has done historically growth will be robust. If I look at the Bloomberg consensus the PE on the group (ex-Tesla) in 2030 falls to 15x versus the S&P 500 around 13x – that is a doubling of earnings for the group. Will the rest of the world grow earnings in the next six years? Will the UK horse come good?
I feel the race will be closer. It will certainly be more interesting, but I believe, at least selectively, BATMMAAN can beat the odds again. They will certainly be competitive in the race and a difficult horse for the rest of the market to outpace.
Source for all data: Bloomberg, 19 September 2024
