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Investment Note #9

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Synopsis

  • In this issue of the Investment Note, we’re taking a look at the “Magnificent Seven”, the latest moniker for US technology giants that include Microsoft, Apple, Alphabet, Amazon, Nvidia, Tesla and Meta Platforms.

  • Apple appears unwilling to spend its substantial cash reserves. We argue this is likely because it lacks compelling reinvestment opportunities.

  • We look at the valuation and growth prospects of these companies after the banner year they had in 2023, and make the case that for the long-term investor these companies might not live up to the lofty expectations that their valuations imply.

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Monty Brewster Empathises

  • Tim Cook has an unenviable problem: how do you spend $162bn? Per CNBC, this is how much cash Apple had on hand at the end of Q3’ 23. This is not a new issue for the Apple CEO either. The company has regularly maintained a significant cash balance and thanks to the Fed, that cash pile is now earning about 5% interest a year (that’s $8bn before they sell a single iPhone). 

  • Even at 5%, cash is not going to deliver the returns that investors want from a company like Apple. Every US investor can earn the same return on cash as Tim Cook can, so they demand greater returns for buying equity in his company.

  • Looking at the valuation of Apple, it seems investors are demanding a lot more. Apple currently trades for 29 times last year’s earnings (or P/E ratio), a hefty premium to the S&P 500 excluding the Magnificent Seven of 18x (source: Lord Abbott, FactSet).

  • For shareholders to get their money back at this valuation level, Apple will need to pay out 100% of current earnings every year for the next 29 consecutive years.

Why are investors flocking to Apple and the rest of the Magnificent Seven?

  • Investors are clearly not expecting Apple to pay out every penny of profit to them for 29 straight years.

  • The assumption then is that these companies will grow their earnings at a faster pace than the rest of the market and that, in a couple of years, what seemed expensive will with hindsight look incredibly cheap.

  • To their credit, this has been the experience of Apple shareholders for the last decade as it grew to be the world’s largest company, worth roughly $3 trillion.

But what about the cash?

  • Returning to its cash reserves, the question we are left with is why, given the valuation demands, does Apple continue to maintain such a large cash balance?

  • It’s not to pay interest on debt or to pay shareholder dividends, which Apple spent about $32bn on in 2023. That’s not a small number, but Apple is a stable enough company that they don’t need to keep over 5 years’ worth of those payments to hand.

  • The answer is almost certainly a lack of reinvestment opportunities which would move the needle on the bottom line of a $3 trillion company.

  • This problem is often echoed by Warren Buffett, whose Berkshire Hathaway maintains a similarly outsized cash balance (although as an insurance conglomerate there are other regulatory factors at play).

  • With iPhone sales flatlining/expected to decline, other sources of revenue are of increasing focus - they’ve expanded into “services” like Apple TV and Apple Music in recent years. These business lines delivered $23bn of revenue in 2023 but given Apple’s size this is not the silver bullet the company is looking for.

  • Outside of a transformative acquisition (unlikely in the current regulatory environment) or another breakthrough product (maybe the Apple Vision Pros will be great), Apple’s valuation will continue to look stretched despite the overall quality of the company, and its cash balance could keep growing.

How do the rest of the Magnificent Seven look?

  • We’ve focused on Apple in detail as it’s the largest of the Magnificent Seven (at the time of writing) but similar broad points can be made about each of the six other companies.

  • Microsoft is also a $3 trillion company and trades at a 37x P/E.  Nvidia is now a $2.0 trillion company (as of the 28th of February) and trades at a 95x P/E. These two companies have made significant forays into AI which may well accelerate earnings, but the market has already baked in substantial growth into the prices an investor must pay today. 

  • Amazon (58x P/E) and Meta Platforms (nee Facebook) (32x P/E) are both coming off strong years, but face headwinds of their own going forward.

  • Meta in particular should be a visceral reminder to investors of the perils of buying expensive companies that stop growing - it lost 65% of its value in 2022 when its metaverse department failed to deliver anything except expenses and user growth stalled in their social networks. Meta completed a round trip early in 2024, recovering its lost ground but it was a very bumpy ride for investors who hung on.

  • Having sold off somewhat in 2024, Alphabet (nee Google) has gone from 27x P/E at year end to 24x P/E, a big premium to the market but positively cheap in comparison to the other Magnificent Seven companies.

  • Tesla completes the Magnificent Seven and is the strangest of them all, but we will revisit this company in a later issue.

Conclusion

  • It is worth noting that in the short-term, valuation has no correlation with returns. Current valuation implies almost nothing about next year’s performance. It is critical however, to long- term returns.

  • Those bullish on the Magnificent Seven will point to reasons for optimism. And ours are not new criticisms either, many investors and commentators have made similar points for years and were proved wrong each time. But earnings are only part of the equation in discussing future returns.

  • The earnings multiple (P/E) investors are willing to pay may very well decrease despite an increase in earnings. Today, investors are happy to buy Apple at 29x but how long will that continue?

  • Over the last decade the average P/E ratio investors were willing to pay for Apple was 21x, a return to this average would mean that the company will need, holding all else constant, to increase revenues by roughly 40% just to keep the stock at the same level it is today.

  • It is possible that these are a set of uniquely wonderful companies who will continue to earn exceptional returns for years to come, but given the valuations, the experience may be much more turbulent for those buying in today.

Financial data sourced at the 16th February from Tikr, unless otherwise noted.

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