The software and semiconductor industries offer numerous opportunities for diversification of your technology and digital stocks beyond the Magnificent Seven.
Seven giant companies dominate the digital landscape, which not incidentally delivered the bulk of investor returns on 2023's ebullient stock markets. But for investors looking to diversify their portfolios beyond the Magnificent Seven, made up of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, several industries within the wider technology arena offer a wealth of opportunities to invest in.
The Magnificent Seven are all leaders in their sectors. Together they account for large chunks of the global and US stock market indices, in terms of both market capitalisation and returns. In the first three quarters of this year, 62 per cent of the return from the global MSCI World Index, and a whopping 84 per cent of the return from the US S&P 500 index, could be attributed to these companies.
It's an unusual situation that leaves investors with a dilemma. Exposure to the Magnificent Seven has paid off handsomely so far this year. But given that this kind of concentrated performance might not continue, how should you best invest for the future?
According to Thomas Schwarzenbach, Head of PM Equities at LGT Private Banking, "Investors need to remember that each of these companies is quite different and comes with its own idiosyncratic risks and opportunities. In addition, while the Magnificent Seven have contributed to significant economic value creation, they do not represent the only stock plays in the digital transformation arena."
Several strategies, used alone or in combination, can help investors position themselves for what's ahead. These traditional portfolio techniques, which range from tried and tested stock selection, to adjusting company weightings within a portfolio, to diversifying towards new opportunities, offer a variety of ways to prepare for a time when the performance of the Magnificent Seven might no longer be so dazzling.
Understanding the role that each of the Seven plays in its specific sector can provide insights into stock selection. As Schwarzenbach explains, "This process is integral to LGT's portfolio management work, where our broad knowledge means we are able to consider the future prospects for each stock on its own merits and within its industry."
Each of the Magnificent Seven have performed exceptionally well because they occupy more or less oligopolistic positions within their industries, and have benefitted from the concentration of value created by the digital transformation.
Taking Alphabet first, Schwarzenbach describes Google, its largest unit, as "the storefront of the world." Whereas once we only had physical high streets where companies leased out real estate to shops, which benefitted both the property companies and the retailers, now storefronts are also virtual, global, and omnipresent.
"Apple too is ubiquitous, providing consumers with the handheld devices that offer access to the digital world," points out Schwarzenbach. Meta's focus on advertising has proved highly successful, eating into more traditional channels like print and TV on the back of the move to digital. Although Microsoft was already a near monopoly, the explosion of growth in cloud computing has reinvigorated the company, as its clients choose the cloud over the expense and hassle of maintaining physical servers and data centres.
The two apparent outliers, Nvidia and Tesla, owe their success to digital transformation, although in somewhat different ways. Chip manufacturer Nvidia hit a hot streak with its graphics processing units (GPUs), which form the heart of modern supercomputing. Integral to gaming technology and encryption software, GPUs are particularly in demand for artificial intelligence (AI).
Tesla, Schwarzenbach says, isn't specifically in the technology business, as it manufactures cars. "But Tesla's cars do incorporate significant software elements and there is no question that the company leads the automotive business today, driving innovation in areas such as battery management systems and aluminium casting for car body manufacturing."
These insights allow portfolio managers to consider the prospects of these stocks within their own industries, which are actually very different, even if they are linked in the imagination of the public - and the market. Just to underscore these differences, Schwarzenbach notes that only three stocks: Apple, Microsoft and Nvidia, are actually in the MSCI Technology Index. Tesla and Amazon are in the MSCI Consumer Discretionary Index, and Alphabet and Meta in the MSCI Communications Services Index.
At any point in time, LGT's stock analysts will have a view on the short- and long-term investment outlook for each of these stocks, both in terms of their internal business prospects and their relative outlook versus other stocks in their industries. This intelligence is the basis for constructing risk-managed portfolios.
Stock weightings within a portfolio can be adjusted to take account of a stock's future prospects. Given that each of the Magnificent Seven companies has a significant weighting within overall stock indices, weighting adjustments are a powerful tool. Overweighting those stocks with continued positive prospects and underweighting those that might encounter headwinds earlier than others, can set up investors for continued success even as the performances of these companies diverge.
Finally, investors need to remember the positive effects that diversification can bring. The Magnificent Seven are not the only stocks that will continue to benefit from the global digital transformation. Schwarzenbach suggests that investors look more closely at the software and semiconductor industries beyond Microsoft and Nvidia when considering diversification of their digital exposure.
"Software development drives a lot of corporate efficiency, which is a trend that is going to continue," Schwarzenbach maintains. And software is a broad and deep universe with companies of many different sizes operating within and across all industries. So although Microsoft has a dominant position in parts of the industry, the demand for software that can promote efficiency continues to galvanize creativity.
Semiconductors are also enablers of the digital future. "What's interesting is that it's a sector with many highly profitable businesses," states Schwarzenbach. Some companies design chips, like Nvidia. Others manufacture them. Still others provide the tools to manufacture semiconductors. "It's a complex ecosystem with no signs of diminishing in importance in the future," he continues.
Investors with an interest in tapping into the theme of digital transformation have a variety of options. These range from considering how to maintain or recalibrate exposure to the Magnificent Seven, to thinking about other players in the technology and digital industries, to looking at newer or smaller companies. It is clear, however, that digital will continue to be an investment focus for years to come, and portfolio diversification will continue to be essential.
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