By Dev Chakrabarti and James T. Tierney, Jr.
Profits have not been consistently rewarded in the equity markets recently. This can change faster than you think.
When seven giant stocks dominate returns, it’s hard for active managers to outperform the market. But we think the pendulum will eventually swing back and more companies with real earning power will start to get the attention they deserve.
Market returns were extreme by many measures in 2023. Magnificent Seven stocks, a group of giant companies seen as big winners from artificial intelligence (AI), accounted for 58% of the S&P 500’s returns last year.
Only 26% of S&P 500 companies beat the benchmark in 2023—the lowest in more than 30 years (Display).
Equal-weighted S&P 500 and MSCI World, which give each index member an identical weight to better represent what the broader market is rebounding, underperforming their peers by 12.7% and 7.1% respectively in one of the tightest years on record.
Earnings weren’t the driver of stock market returns in 2023—instead, it was mostly price-to-earnings multiple expansion.
The AI hype wasn’t just hype. Investors were drawn to Magnificent Seven stock’s potential to cash in on the revolutionary technology – a particularly attractive proposition in an uncertain macroeconomic environment.
These were difficult conditions for active capital managers who aim to diversify holdings, even in concentrated portfolios with a relatively small number of stocks.
While Magnificent Seven stocks include great companies with strong businesses, many active managers are careful to hold the entire group of highly correlated stocks, which make up about 29% of the S&P 500.
Profits, Profits, Everywhere?
While the consensus is bullish going into 2024, we don’t expect a sudden surge in earnings across the board. Earnings will face continued headwinds due to persistent wage inflation, slowing GDP growth and more limited pricing power as inflation falls.
Meanwhile, heightened geopolitical risk could fuel instability as the Russia-Ukraine war continues, the Israel-Hamas conflict destabilizes the Middle East and the US enters a polarized election campaign.
Ongoing uncertainty may continue to support near-term positive sentiment for US mega-caps.
And with operating margins near record levels in the US and globally, we think companies across the broader market will struggle to meet consensus earnings forecasts of around 13.4% in the US and 8.5% globally.
However, over time, we believe the relative earnings advantage of Magnificent Seven stocks will narrow (Display).
This is because there is more potential for profit growth in the market than meets the eye. While last year’s total earnings were weak, a large number of companies outside of the Big Seven stocks have attractive earnings growth profiles over the past three years.
In fact, about 40% of the S&P 500’s weight beyond the seven largest companies is in companies that grow earnings by between 10% and 30% from 2020 to 2023 (Display).
More than 20% of the benchmark weight is in companies growing at least 30% per year. MSCI World shows similar EPS growth characteristics.
Of course, this three-year period was not a normal environment. It included the boom and bust cycle during COVID-19, when many companies experienced a sharp decline in revenue followed by a rapid recovery.
Investors also faced rising inflation, rising interest rates and prospects for normalization. However, we think that the long view suggests that companies with different sources of earnings growth potential can be found.
Quality is still the North Star
It’s easy to lose faith in the long term when real growth companies don’t pay off. And it’s even harder to stay the course when a small group of giants are running away with all the returns.
But we think investors with a long-term horizon should stay focused on companies that have high-quality businesses to support sustainable earnings growth over the next three to five years.
Companies with a competitive edge, pricing power, innovative products, and top-notch management possess the business traits necessary to go the distance—even if they’re not winning the short-term return race because of unusual market conditions.
True growth will pay off
AI isn’t the only growing game in town. In the healthcare industry, new products targeting worldwide health crises, including diabetes and obesity, can capture huge potential for unmet medical needs.
Software companies with strategic solutions for continuous cloud migration should benefit from the structural growth of a global technology trend. More digital payments and open banking services will create opportunities for fintech companies.
Finding companies like these is not easy. Even in the best of times, few can translate compelling business drivers into consistent year-over-year earnings growth.
But our research suggests that companies that produce strong revenue growth for at least three consecutive years tend to beat the market over time.
The markets haven’t consistently rewarded companies like these lately. Enthusiasm for Magnificent Seven stock has been so unbridled that some AI darlings’ stock prices have continued to rise even when their earnings reviews were negative.
In our opinion, such abundance cannot continue indefinitely. Now is the time for investors to identify laggard firms with relatively attractive valuations and resilient earnings potential.
Shares of companies like these are prime candidates for a revaluation if more signs of a soft landing pile up and bolster confidence in a broader corporate recovery.
The views expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the views of all AB Portfolio management teams. Images are subject to revision over time.
Editor’s note: The bullet points for this article were selected by Alpha’s research editors.