Is ‘Bad Breadth’ Putting Your Global Portfolio at Risk?

• Seven giant technology-related stocks now drive a large portion of index returns.

• Many passive investors have grown concerned, and we believe rightly so, about the concentration risk this presents.

• We propose approaching the 'Magnificent Seven' through a different lens – not as a group, or defined by sectors or factors, but through the growth and cyclicality of each business and its stage of development.

• This bottom-up analysis and active security selection may still result in owning some of the Mag Seven individually, but as part of what we believe to be a greater whole.

Once there was the 'Nifty Fifty', a collection of large-cap blue-chip growth stocks, including Eastman Kodak, Polaroid, IBM, Sears, Xerox, and forty-some other companies with strong earnings and even loftier valuations, that lorded over the US equity market of the 1960s and early 1970s. Their subsequent crash became a stark example of what can happen when investors overlook fundamentals for too long and base their decisions on popular sentiment and market folklore.

Today, there is the 'Magnificent Seven', an even more concentrated cohort of US mega caps (named after a spaghetti Western starring Yul Brynner and Eli Wallach released, fittingly enough, at the dawn of the Nifty Fifty era) that, like its predecessors, has grown so dominant it has come to be viewed almost as a sector unto itself.

By the end of 2023, Nvidia, Microsoft, Apple, Tesla, Meta, Amazon, and both share classes of Alphabet (which in some references makes for a 'Magnificent Eight') accounted for 15.4% of the market cap weight and 41.8% of the year’s gains for all 3,000 stocks in the ACWI Index. At one point in the first quarter of 2024, those percentages had ballooned to 17.2% and a staggering 72.2%, respectively, before settling out at 17.5% and 28.1%.

Figure 1: The Seven Stocks That Ate the ACWI

Source: FactSet, PineBridge Investments as of 31 March 2024. The benchmark referenced is the MSCI All-Country World Net Index (ACWI). For illustrative purposes only.

This 'bad breadth' has left many investors in a quandary. Even those too young to remember the rise and eventual fall of once-indominable Nifty Fifty constituents may have fresh memories of how the Magnificent Seven contributed over a third of the market’s 18.4% swoon in 2022. Index investors who have cheered the Seven’s impact on their portfolios before and since may realize at some level that such a passive allocation can’t be counted on for broad market diversification when most of its returns are coming from just seven stocks. And yet, not investing in the Magnificent Seven may seem foolish too, leading investors to feel stuck.

We believe there is a way to achieve diversification, manage risk, and still attain compelling results while maintaining very similar style and market beta exposures to the benchmark – even if that means underweighting the Mag Seven.

This raises a couple of questions:

• How is that possible?

• What does it tell us about the Magnificent Seven and how to think about holding them (or not, as the case may be) with some greater degree of clarity and confidence going forward?

Origins of the Mag Seven clique

Spawned by the FANGs/FAANGs, the Magnificent Seven evolved as names changed, dropped, or were added. What becomes clear with the benefit of hindsight is that the agglomeration has more to do with how the Seven performed and their size than how each fundamentally operates as a business. There is no mistaking that since the early 2010s, each of the Magnificent Seven has gone wildly up. Quarter after quarter, for years on end, all have delivered on earnings and guidance. A similar confluence of powerful secular themes has powered their rise. They have also been quite transformative in the products and services they have brought into the world.

But there are differences between them as well. Many people think of the Mag Seven as 'technology growth stocks'. In fact, only Nvidia, Microsoft, and Apple are in the information technology (IT) sector. Stylistically, all are currently included in the S&P Growth Index, but there have been multiple periods when Apple was in the Value index. As recently as 2022, Meta was considered a value stock, and Amazon and Microsoft were assigned to both the Growth and Value indices.

These distinctions suggest that the Mag Seven may be more diversified than commonly assumed – but also how arbitrary and misleading traditional classifications such as sectors and factors can be. What does it mean, for instance, that Microsoft has dropped back out of the Value index or Amazon is in consumer discretionary instead of IT? And how much does that tell us about the underlying growth and cyclicality of the business?

Lifecycle research: a different framework

It was precisely for that reason that our Equity team developed a different sort of stock categorization framework. We call it the Lifecycle Categorization Research (LCR) framework, because instead of sectors, acronyms, or 1960s movie titles, it groups stocks by the growth and cyclicality characteristics of their business models and the stage of their development. We compare companies expected to regularly grow their earnings by a high rate over extended periods to other similarly 'High Stable Growth' companies, for example, and mature cyclical companies to other 'Mature Cyclicals'. We then use evaluation criteria particular to each category, which we think results in more like-to-like comparisons and further highlights the difference of opinion between us and the Street.

Viewed through this X-ray vision, we see the Magnificent Seven as breaking down into four separate categories:

Four of the seven are High Stable Growth companies. As a frame of reference, other recognizable companies we classify in the same category include Eli Lilly and LVMH.

Two are in our High Cyclical Growth category, most directly comparable to companies like Sherwin-Williams and Hitachi.

One is a Mature Cyclical company, sharing many of the same characteristics as JPMorgan Chase.

Furthermore, using these criteria and comparisons as our guide, as of the end of the first quarter of 2024 our Lifecycle Categorization Research would determine that four of the seven fit its criteria, while three did not.

Why didn’t the other three fit the criteria?1

In each case, our Lifecycle approach made for clear and straightforward rating decisions.

One perhaps striking omission that our Lifecycle process identified was a company we categorized as a Mature Cyclical and is one of the very largest weighted stocks in the ACWI Index. As noted, we had nothing against cyclical companies, or even against Mature Cyclical companies. We were, however, concerned that the market appeared to be valuing this company like a High Stable Growth company, as investors underestimated the mature cyclical profile of the company’s hardware business and overestimated the growth opportunities of its services business.

With billions of its signature products in circulation, the company’s biggest enemy was its own success. There were only so many more underpenetrated markets or new design features it could roll out to encourage purchases before customers’ old units break, and to keep growing its earnings at the same pace it had in the past. To compensate, the company had sought to grow its various less-cyclical recurring-revenue services businesses, but even these were showing signs of deceleration.

We had identified similar issues with another Mag Seven company that we categorized as High Stable Growth, on top of concerns about its reliance on purchase subsidies, the uncertainties surrounding the pace of its product penetration, and apprehension about its top management. Using our Lifecycle framework, we believed the company was following a similar pattern to the firm noted above when years ago the first company shifted (in our categorization) from a High Stable Growth to a Mature Cyclical business. While this second company was classified as a High Stable grower, its growth was maturing, and the market had yet to discount its share price to reflect the change.

Valuation played prominently into our view on another key Mag Seven company as well, particularly its valuation relative to other opportunities. Part of the challenge, in our view, was that the company was really two businesses (and two Lifecycle categories) in one: While its web services offered fantastic growth and generated most of group’s profits, we found other cloud companies more attractive, and the same held true for its ecommerce business.

The four Mag Seven our proprietary process favored1

Our evaluation of the Mag Seven companies that did fit our criteria all came down to their exposure to and unique ability to capitalize on what might be the single most powerful and transformative theme since the birth of the Internet: generative AI.

We looked for the secular nature of the theme to boost growth prospects in ways the market still wasn’t capturing for both the High Stable and High Cyclical growers among the four.

One company, for example, had its ownership stake in a generative AI tool along with its own offering, both backed by the stickiness of its existing service offerings. Because all its products are effectively sold as features of the same platform, it’s frictionless for customers to add new services. It’s a simple plug-and-play versus having to sell incremental units: almost a textbook recipe for High Stable Growth.

Still, generative AI is new, with much about its future unknown. That is part of the reason why two other Mag Seven companies exhibited positive characteristics – each has its own offerings and market applications built atop its own existing, highly profitable franchises.

And lastly, we were high on a Mag Seven supplier of graphic processor units (GPUs) that powered the whole revolution – which we believed position the firm for continued cyclical growth.

Trimming and pruning

We believe another part of what distinguishes our resulting views on the Mag Seven is balance. Our Lifecycle framework is designed to be a key alpha engine. However, for it to work consistently, bottom-up stock selection needs to be the only source of alpha, not muddied by top-down macro bets via large over- or underweights to the benchmark’s own underlying characteristics and exposures to the business cycle. This doesn’t mean allocating to all the Mag Seven or even every sector, but it does call for a balanced collection of companies whose combined representation of growth and cyclicality is similar to the benchmark’s.

Spread mostly evenly as they are across the benchmark’s two largest Lifecycle categories, this high-quality quartet not only provided exposure to four of the most robust individual growth stories in the markets today. But it is important to consider other equally-high-conviction opportunities to avoid the 'bad breadth' that might come from a less thoughtful approach.