Looking beyond ‘Mag 7’?

In an interesting FT article over the weekend, columnist John Plender boldly declared (£): “The Magnificent Seven tech stocks are no longer magnificent.“

The author’s incisive claim derived from the fact that many Mag7 companies (such as Microsoft and Google) are vacuuming their financial resources to invest in AI infrastructure buildout. Mag7 debt loads are clearly increasing and their free cash flows dwindling. This will weigh on Mag7’s shareholder returns in the years to come.

Even Apple, the largest Big Tech that is eschewing this AI buildout race, faces increasing margin pressure due to component shortage. Its share price recently slumped nearly 7% from all-time highs as revenue and margin visibility drop (see below).

But tech bulls will strongly counter the bearish argument that Mag7 is no longer a force to be reckon with.

For one, they will point to Amazon (AMZN), which saw its share price jump to record price highs lately on strong growth in its cloud business. AWS, Amazon’s cloud unit, registered $42 billion in quarterly revenue last week, a growth of 36% y-o-y. This is the strongest growth in over 18 quarters, with AI contributing significantly to the bottom line. In CEO’s words: “AWS is ‘booming'”.

Meanwhile, Google, Microsoft and Nvidia are all trading near their fresh peaks again, as investor sentiment returns. Microsoft, in particular, surged and overturned months of bearish price trend. How can the Mag7 theme be over when the market is clearly favouring the sector?

Moreover, there is this ‘circular effect’ in which spending from one Big Tech flows to another Big Tech. The enormous AI training clusters, for example, are raising demand for cloud storage. This increases the top line revenue of major cloud provides (AWS, Azure).

Meanwhile, Nvidia recently concluded a staggering $500 billion deal with South Korea’s SK Group while Samsung and Broadcom signed a $200 billion collaboration. These deals will only strengthen the overall growth of the Mag7.

Once these AI platforms are dominant enough, cash and profits will swell. The resulting AI winner will rake in excess profits for decades (like Google). After all, technology is a ‘winner-takes-all’ environment.

The biggest risk to the AI boom, of course, lies in the circular effect. Circular financing and circular investment mean that if one falls, the entire network of deals may be threatened and undone.

The chart below shows this concentration risk. If, for example, AI revenue falls short, all else will tumble because the industry would have excess ‘everything’, from data centres to chips to memory. Remember, this circular effect can be highly virtuous at the beginning but deeply vicious at the end.

This year, Mag7 companies still have a drawer of free cash flow. Once that is used up, things will look rather tricky.

Where will we see this investment risk emerge? Credit (ie bond market) usually develops the first crack.

For example, pay attention to the Credit Default Swap (CDS) of these Mag7 bonds. They will give you a good indicator of what the market thinks of Mag7 financial health and whether these tech companies have enough cash flow to service their debt.

Oracle (ORCL), for example, recently suffered a massive spike in its CDS because investors significantly re-price (downwards) ORCL’s debt outlook. They are expecting some financial turbulence ahead for the tech firm.

Other Mag7 CDSs have too risen recently, but not as much as ORCL’s. In all, we should occasionally take a quick look at these instruments to get an idea of what debt investors are thinking of.

Where should we focus our attention on?

Back to original thesis, if Mag7 as a group is a fading industry, where should we look beyond this group of multi-trillion companies? I highlight five potential areas below:

• “493” – large-cap equity outside Mag7
• Small-cap stocks (eg Russell 2000)
• US Financials
• Selected European markets – Spain, Italy, Austria
• Buyback Achievers

The first area is obviously the “493” group – all the S&P stocks outside the Mag7. There is already an ETF that does this strategy. (Nowadays, there is an ETF for every conceivable trading strategy!)

The Defiance Large-Cap ex-Mag ETF (XMAG) tracks 493 stocks beyond those Mag7. Price-wise, you can immediately see that the fund is less volatile than many Big Tech due to higher constituent numbers. Lower volatility, however, brings lower return. This may not be what investors want.

At the opposite spectrum of Mag7, we have the small cap stocks. The Russell 2000 index is an alternative area to put some capital in.

Below is the weekly chart of the Russell 2000 ETF (IWM). The trend here is long-term positive following a breakout at 250 last year. Yes, it wasn’t a “clean” breakout at that area but the bulls managed to run the index to new multi-decade highs.

Sector wise, financial appears to be a bullish one.

The iShares Financials’ (XLF) long-term trend touched new cyclical high recently. Banks like JP Morgan (JPM) and Bank of America (BAC) are establishing new price highs above their 2007 peaks.

Even the KBW Bank ETF (KBW) appears to be heading the same way. Each consolidation is a step higher than before. Near-term target at 100.

Outside US, some European country ETFs are rallying into new cyclical highs again.

iShares Spain (EWP), iShares Italy (EWI) and iShares Austria (EWO) are registering new long-term highs at USD-level. Germany (EWG) is another potential asset to buy as prices flirt near the breakout level. Europe at the macro level seems to be behaving slightly differently than the US. This may create some orthogonal portfolio returns.

Lastly, I would like to highlight the ‘Buyback’ theme.

This Buyback Achievers (PKW) ETF tracks companies that are retiring their public equity. This suggests that their underlying businesses are strong and cash-generative. Chartwise, the ETF is performing well as prices just broke out to new high. Note the “shallowness” of the bear trend back in 2022.