Investment trusts find value beyond the magnificent seven

The S&P 500 has been on a tear since October last year, thanks primarily to the AI narrative and demand for the so-called Magnificent Seven mega-cap tech stocks.  

In 2023, growth from these tech titans (Meta, Tesla, Nvidia, Apple, Alphabet, Microsoft and Amazon) was responsible for around two-thirds of the S&P 500 index’s total gain. However, this fell to just 37% of the index’s increase in the first quarter of 2024, according to Morningstar1.

So, what does this shift mean for investors? Can the rally be sustained? Is there value in the broader market, or does the future hinge on just a handful of mega-cap stocks?

The Association of Investment Companies (AIC) asked fund managers of investment trusts in the North America and North American Smaller Companies sectors if they believe there are meaningful opportunities away from the Magnificent Seven, and, if so, where they can be found. We have collated their responses below.

Kirsty Gibson, Co-Manager of Baillie Gifford US Growth, said: “There are pockets of exceptional opportunity in the US in both public equity markets and in private companies. This is true inside and outside the ‘Magnificent Seven’, which is a catchy but not very meaningful name for a group of large businesses. Investors might do well to recall that only three of the Magnificent Seven survive to the end of the 1960 movie.

“In long-term investing, it pays to be selective.  We own some of the largest businesses that provide essential foundations for the shift to accelerated computing, like the chip maker NVIDIA. We also own lesser-known public companies that could provide the infrastructure for the next computing age. Datadog helps businesses manage the exponential rise in the volume, complexity and importance of data. Owning the right digital picks and shovels in an AI gold rush could be very profitable.”

Felise Agranoff, Manager of JPMorgan American Investment Trust, said: “In short, yes, we see opportunities. While our top holdings, such as Microsoft and Meta, reflect our strong conviction in the AI sector, we also invest in the lesser-known companies enabling the AI boom. The infrastructure required to support generative AI, such as data centres, provides opportunities for investors. For instance, we hold positions in Trane Technologies, which specialises in building systems to cool the vast data centres essential for AI operations, and Quanta Services, which contributes to the development of electric power infrastructure crucial for supporting AI energy needs.

“Elsewhere, we have significant exposure to financials, including a long-term position in Bank of America as well as a newer holding in Morgan Stanley, which is less interest rate sensitive. Our large financials exposure is not a single bet on the level of rates or the slope of the yield curve. Instead, we recognise that diversification is critical.”

Greg Eckel, Portfolio Manager of Canadian General Investments, said: “After having risen so far over time and posted outsized performance metrics, it is logical to expect that the disconnects that have arisen between the Magnificent Seven and almost everything else in the market should at some point begin to correct. It is a natural cycle in the markets that has repeated in many forms over the years, but the difficulty for investors has always been in the timing. Having said that, there will be opportunities.

“One of the most downtrodden areas in the markets has been interest rate sensitive stocks, which have been disproportionately impacted by increasing interest rates. If there is a clear prospect of rate reductions, these investments should do well. In Canada, we would point to our major Canadian bank stocks as good candidates for outperformance in this type of scenario.”

Chris Berrier, Portfolio Manager of Brown Advisory US Smaller Companies, said: “The concentration in a few large-cap technology companies is historically acute and the relative valuation gap to small caps is attractive. Historically, when this situation has ended, which it will, a period of corresponding outperformance for small caps follows.

“Even though we are aware that geopolitical and economic risks abound in the short run, we believe successful navigation of the present should yield dividends to small cap investors in the future.”

David Zhao, Co-Manager of the BlackRock Sustainable American Income Trust, said: “We are finding a number of opportunities. In healthcare, for example, developments in GLP-1s – diabetes drugs with positive weight-loss side effects – are creating waves. The drug makers have benefited, while other parts of the healthcare complex brace for a drop in demand. If obesity levels fall, people are likely to need fewer insulin pumps and sleep apnoea machines, for example.

“There are also opportunities in the re-engineering of global supply chains. The US Inflation Reduction Act, CHIPS Act and infrastructure bill create incentives for US manufacturers to build operations closer to home. We see potential divergence in the auto industry, as an example, where some manufacturers may qualify for greater EV subsidies than others.”

What stocks are benefitting from the expanding US market rally?

Felise Agranoff, Manager of JPMorgan American Investment Trust, said: “We are finding opportunities in healthcare with the addition of Kenvue, which was recently spun off from pharmaceutical giant Johnson & Johnson. Their collection of household brands, such as Listerine, BandAid and Neutrogena, are often found in many homes. We believe the company should enjoy strong growth as a standalone entity as it seeks to better capitalise on broader health and wellness trends.

“We also view Regeneron as one of the highest-quality companies in the healthcare space. It is among the most innovative biotech companies which has evolved to have all the technologies in-house to develop new drugs in large markets. It has never relied on acquisitions, buybacks or financial engineering to drive earnings, and its founders are still involved in running the company.”

Kirsty Gibson, Co-Manager of Baillie Gifford US Growth, said: “Physical infrastructure will need to keep up with digitisation. SpaceX is transforming the economics of space launches, and that has enabled it to develop its vast Starlink communications network. The drone delivery company Zipline is expanding from highly specialised medical deliveries in Africa to much broader commercial delivery applications. We’ve owned both of these private companies in the US Growth trust for years and are excited for their next phase of growth.

“We are always interested in the second-order effects of big technology shifts. Which companies will build new and valuable businesses on top of this infrastructure? These opportunities are springing up across industries. In the consumer space, the education app Duolingo has made great strides in building AI into the design of its products and is generating more tailored and effective teaching for its subscribers. Sweetgreen, a chain of salad restaurants, is beginning to roll out automated kitchens across its network. In healthcare, a deepening understanding of the genetic make-up of patients and diseases is enabling the rapid development of more effective drugs. Companies with a software mindset could code the next generation of drugs using the building blocks of DNA. Moderna’s mRNA platform has tremendous potential that the post-Covid sell-off appears to underestimate.”

Chris Berrier, Portfolio Manager of Brown Advisory US Smaller Companies, said: “Although concentration of returns in the large-cap space has been a discussion topic for years, this phenomenon has leaked down the market cap spectrum recently. The theoretical exclusion of only two tech stocks (Super Micro Computer and Micro Strategy) would likely have caused the returns of both Russell 2000 Index and the Russell 2000 Growth Index to drop below 4% for the period.”

Greg Eckel, Portfolio Manager of Canadian General Investments, said: “A change in the global supply chain is already underway due to some of the geopolitical issues that are making headlines, but it will take time and money. Interestingly, issues of security and supply are already being considered by some investors in reference to uranium, which is needed to fuel the renaissance of nuclear energy. Canada is becoming an attractive source for a ‘friendly’ and dependable Western supply with the prolific Athabasca Basin being home to investments like Cameco Corporation and NexGen Energy.”

How sustainable is the current rally?

David Zhao, Co-Manager of the BlackRock Sustainable American Income Trust, said: “Based on analysis we’ve done on the US market (using the S&P 500 equal weighted index) we project that the earnings growth of companies outside the Magnificent Seven will accelerate into the second half of this year. This potential acceleration could further sustain the equity market rally and see it broaden.”

Greg Eckel, Portfolio Manager of Canadian General Investments, said: “I believe the stock rally is sustainable although I would expect at least a pause, if not a pullback in the short term, after such a big run from October 2023. But underlying fundamentals supportive of continued growth remain in place and, although slowing in some areas, suggest a healthy environment for market success going forward.”

Chris Berrier, Portfolio Manager, Brown Advisory US Smaller Companies, said: “The large-cap stock rally can largely be attributed to the Magnificent Seven. Capital will at some point dissipate from these companies and trickle down to smaller caps, which will broaden out the rally across other parts of the market.” 

Kirsty Gibson, Co-Manager of Baillie Gifford US Growth, said: “The US remains the innovation capital of the world. It has world-leading hubs of expertise in most industries, great structures for supporting business growth and a huge domestic market to grow into before they take on the world. It goes deeper than that though. It’s part of the culture – the land of opportunity. Entrepreneurs travel to the US to set up their business. There’s no better place to make it big than America. That’s why we think it will continue to produce more than its fair share of the world’s greatest businesses. And we can own them as public and private companies in the trust.

“We don’t know whether the stock market rally will be sustained, or how the share prices of seven large companies will move in the next few months. We would encourage people to match the focus of their attention to their investment time horizon. We take a five-to-ten-year investment view, and that’s always where our focus is. Through that lens, earnings and revenue growth potential drive opportunities. This often gets missed in the noise. Companies that grow the most tend to deliver the best returns to investors. And right now, we’re being offered the greatest breadth of growth opportunities that I can remember since I began managing the US Growth Trust.”

What are the major risks to a broader rally?

Greg Eckel, Portfolio Manager of Canadian General Investments, said: “First and foremost remains inflation. Although trending in the right direction, a turnaround would upend the interest rate considerations, a key to the market dynamic at this time. Geopolitical risk is at heightened levels. Aside from potential escalation in the ongoing conflicts, there is a simmering and potential explosive issue around trade and protectionism, with tariffs being used as a weapon. Global trade efficiencies assist in productivity measures and their reduction would curtail economic potential.”

David Zhao, Co-Manager of the BlackRock Sustainable American Income Trust, said: “Higher valuations, inflation and rates may mute overall stock market returns relative to the previous decade. There is also scope for political disruption arising from a busy election year around the globe. It is also possible that a number of the world’s major economies fall into recession. However, we believe these headwinds are readily managed by a focus on quality and on areas of real value in the market.

“We believe 2024 may see the market grow less concentrated and look beyond the AI giants. As our process focuses on those companies with strong fundamentals and sound future prospects, we welcome this shift.”

Felise Agranoff, Manager of JPMorgan American Investment Trust, said: “Easing inflation and improved prospects for growth have helped fuel optimism for a soft landing. However, be it the US election, higher policy rates or geopolitical tension, risks remain that could push the economy into recession in 2024. Through the volatility, we continue to focus on high-conviction stocks and take advantage of market dislocations for compelling stock selection opportunities.”

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Notes to editors

1. Source: Morningstar quoting S&P Global Indices and Dow Jones Market Data (‘The Magnificent 7 are no longer the only stocks driving S&P 500 to record highs’, 31 March 2024)
2. The Association of Investment Companies (AIC) represents a broad range of investment trusts and VCTs, collectively known as investment companies. The AIC’s vision is for closed-ended investment companies to be understood and considered by every investor. The AIC has 330 members and the industry has total assets of approximately £273 billion.
3. For more information about the AIC and investment trusts, visit the AIC’s website. 
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