Growth and the Price of Growth: A Conundrum

By: Justin Larson, CFA

Throughout 2023 and into 2024 the common narrative surrounding the outsized performance the largest US tech companies have enjoyed relative to the rest of the market has been their price moves are justified given their impressive underlying growth numbers. And impressive they have been. All seven of these stocks experienced significant drawdowns in 2022 so coming into 2023 multiples had contracted and expectations were low. That created an environment for positive surprises, and positive surprises came rushing in like an AI tsunami overtaking a coastal web 2.0 city. Fast forward to early 2024, and after over a year of frankly unprecedented and eye-popping gains and growth, multiples are again high and expectations again stratospheric. It was only in 2021 that similar expectations were baked into the big tech cake (replace AI with metaverse, web 3.0, blockchain, etc.) – as most other tech industries began selling off in mid-late 2021 and the rest of the market with them into 2022, big tech held up well on the premise they were the new defensive names in the market. Until they weren’t. From April 4th of 2022 through the end of that year, the average “Mag 7” stock lost 43% of its price while the S&P 500 lost 16.2% (Y Charts). So we know these names aren’t immune from weakness, even deeper weakness than the broad market.

That got us thinking about the future. At these prices, with these expectations, is big tech or the “Mag 7” really the best growth around? Are there better potential growers at better prices, or is the narrative true, that the “Mag 7” is the only way to gain access to outsized growth and the price paid is justified today? Thankfully, we don’t have to reinvent the wheel to assess. Our admired friends at Richard Bernstein Advisors (RBA) have been sharing similar thoughts and put together the below chart.

What RBA points out is what the headline narratives miss, and I’ll quote directly from RBA:

“Investors should seriously question the narrow leadership and valuations of the so-called Magnificent 7 stocks. Whereas some of today’s Magnificent 7 do have strong fundamental growth, that growth isn’t uniform within the seven stocks nor is it unique relative to many non-Magnificent 7 companies’ growth prospects. Chart 7 shows there are currently about 140 stocks within the G-7 equity markets (US, Canada, Germany, Japan, France, the UK, and Italy) projected to grow earnings 25% or more over the next year. Most importantly, only 3 of the Magnificent 7 pass the screen and the fastest growing of the Magnificent 7 ranks only 25th.”

So not only are the growth prospects in these seven stocks not uniform, but they’re also not even unique to those names. That doesn’t diminish the impressive (which isn’t even the right word – it’s been mind bending) growth of companies like Nvidia or Microsoft or Meta. That’s why the next step of the analysis should be an assessment of price. The price you pay for something, especially if you’re a true long term investor is important. In fact, it may be the most important. Per Bank of America Research, 88% of 10-year S&P 500 returns have been explained solely by how cheap or expensive the index is at the time as measured by the price-earnings ratio. That’s a direct reflection of price. In other words, if you’re buying something to hold onto it for a while, your entry price is crucial to your future returns. However, over shorter horizons, price may not matter as much as other factors.

If we concede growth in the Mag 7 names has been and will continue to be great, are they still a good value for long term investors at current prices? For this we can look at the price-sales ratio (P/S). The P/S ratio can be a better barometer for relative expensiveness or cheapness for growth companies than having earnings in the denominator. With the caveat these companies aren’t in exactly the same industry and so a single metric of comparison may not suffice, a higher P/S ratio implies higher growth needs to be realized in the future to justify the price today. This can mean missing those growth estimates can have a more adverse impact on stock price than a company with not-so-lofty-growth baked into the price already.

If we look at P/S ratios for a broad growth index like the Russell 1000 Growth, we can assess how markets are pricing and viewing future growth for growth companies themselves. The ETF IWF tracks the Russell 1000 Growth index, and its weighted average P/S ratio currently sits at 4.535 (Y Charts). Below are the P/S ratios for the “Mag 7” companies (Y Charts):

Apple (AAPL): 7.365 (a 62% growth premium)

Microsoft (MSFT): 13.29 (a 193% growth premium)

Nvidia (NVDA): 32.26 (a 611% growth premium)

Amazon (AMZN): 3.177 (a 30% growth discount)

Alphabet (GOOG): 5.853 (a 29% growth premium)

Meta (META): 9.401 (a 107% growth premium)

Tesla (TSLA): 7.213 (a 59% growth premium)

These growth premiums (save for Amazon) show us direct evidence of the lofty growth expectations baked into current “Mag 7” prices, some more extreme than others. To us, this means one of three things: these companies will grow into these lofty multiples, but forward returns won’t be as impressive because it’s expected they will, the companies will grow beyond these already lofty growth estimates and continue to deliver outsized returns, or these companies fall short of these expectations and forward returns suffer for that shortfall. Of course, not all seven are likely to be equal moving forward, but the point remains: in order to further benefit to the degree they have vs. the rest of the growth market, these companies better deliver perfection again and again and again and again. And a few more times. All this must come to fruition in a competitive US economy that prides itself on innovation and disruption. Essentially, we see entering these stocks now as a bet against every other company in this great country making any strides in these technology arenas that would create competition for the big names. That’s a high hill to climb, but market history and our country’s own history suggests the smart money may be in betting on everyone else over the incumbents, if your time horizon supports patience. We think there are more attractive areas, even in the growth space, to deploy capital that markets won’t be able to ignore for long. Rarely do companies trading at these prices against underlying revenues deliver on these lofty expectations, and even more rare is seeing market consensus be right regarding who those growth gains accrue to long-term.

We’re not advocating against indexing, we’re not advocating against the principle of market-cap weighting, we’re not advocating against big tech, and we’re certainly not advocating against emerging technologies. We’re advocating for rational thinking. Think about the price you’re paying for an investment and think about what those prices tell you about expectations. This thought exercise paired with some strong analysis (much deeper than we go here) can often lead to tremendous opportunities to build your wealth. But it takes some patience, effort, and some discipline. At times when those characteristics seem scarce, the odds tilt to the patient investor’s favor.

Please reach out to our team if you’d like to discuss this topic or any other investment topic that’s on your mind. Our team is always available to assist.

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Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Richard Bernstein Advisors is not endorsed or affiliated with Innovative Planning Group or LPL Financial.