Michael Brush: 3 reasons it’s safe to own the ‘Magnificent Seven’ stocks

1. The “rich” valuations are entirely justified: The most common knock on the Magnificent Seven is that they are “overvalued.” On the surface, this argument seems valid. These stocks’ p/e ratios appear high. Recently their average forward p/e was close to 35, more than twice the long-term average p/e of 16.5 for the S&P 500
SPX,
and a p/e of 15.6 for this index if you take out the Magnificent 7. 

But what if those elevated p/e ratios are justified? That’s actually the case, says Tim Murray, the capital markets strategist at T. Rowe Price. “The outlier valuations that these stocks carry is absolutely matched by the fundamentals,” says Murray, who is otherwise cautious on the stock market in part because of what he believes is the potential for a U.S. recession. 

Here’s Murray’s logic on the Magnificent Seven. The starting point is that Murray thinks return on equity (ROE) is a good one-size-fits-all metric for capturing the fundamental strength at companies. ROE is defined as net income divided by total equity. It is a basic measure of how well managers are running a company. “The Magnificent Seven have outlier valuations, but the ROE, the fundamentals, are every bit as much of an outlier,” he says. 

He puts the average ROE for the Magnificent Seven at 33%. That’s twice the ROE for the U.S. stock market, which is 16.47%, according to NYU Stern School of Business finance professor Aswath Damodaran. While ROEs vary by sector, in general an ROE of 15% to 20% is considered good. Many of the Magnificent Seven are way above that. At Nvidia, for example, the ROE is 40.2% while Microsoft has an ROE of 39.1%. 

“What that’s telling you is you shouldn’t just expect the valuations to come down because of gravity,” says Murray. “The reason they would come down would be if they are unable to sustain those fundamentals.” 

2. The AI trend is their friend: The Magnificent Seven should be able to sustain their fundamentals because they all have exposure in one way or another to the big tech trends — including the biggest one of all: artificial intelligence (AI). 

“Their ROEs will stay at least at these levels or expand from here because these are the companies best positioned for AI and this incredible revolution,” says Dom Rizzo, a technology portfolio manager at T. Rowe Price.

The most obvious direct beneficiary is Nvidia, since it sells chips, software and related gear that’s crucial to the computer processing that powers AI, Rizzo says. Its H100 chips (and the B100 to launch next year), CUDA software, and Mellanox networking and switch technology power AI infrastructure in the cloud. 

“Nvidia has the full portfolio solution,” he says. Nvidia beat estimates and raised earnings guidance so much this year the stock has actually gotten cheaper, Rizzo adds.

Read: Here’s why Nvidia is a compelling stock when compared with the rest of the ‘Magnificent Seven’

Citing industry sources, Rizzo predicts that the AI chip market will grow 50% a year through 2027 to $150 billion from $30 billion this year. (Beyond the Magnificent Seven, the three other most attractive chip-related AI plays are Advanced Micro Devices
AMD,
-3.46%
whose MI300 chipset competes with Nvidia AI chips, Taiwan Semiconductor Manufacturing
TSM,
-2.78%,
and ASML Holding
ASML,
-1.66%,
which offers extreme ultraviolet (EUV) lithography technology needed to print sophisticated chips.)

Alphabet, Microsoft, Apple, Amazon.com and Meta will be using AI in chat, search, content generation and other applications yet to be seen. They’ll offer AI computing infrastructure. Tesla will use AI in autonomous driving. That will be the next big breakthrough for the company, notes Ron Baron, of Baron Capital Management. The firm has a concentrated bet on this development, or 10% of its assets under management invested in Tesla. That’s big, for a mutual fund shop.

3. AI productivity gains will boost Magnificent Seven stocks: We are already seeing big productivity gains in the U.S. economy, thanks to the large increase in capital spending spurred by the tight labor market. Productivity, defined as output per hours worked, was up 4.7% in the third quarter. It jumped 3.7% in the second quarter. 

The gains are a big deal. Few stock analysts talk about productivity. But the gains are key to the economy and the stock market for two reasons.

First, they tame inflation. When companies get more output per employee, they feel less pressure to pass along supplier price increases. Second, productivity gains boost profits. So they are good for stock market performance. A big part of the reason for the mid- to late-1990s bull market in stocks was the ongoing productivity improvement. 

Besides the growth in productivity linked to greater spending on new equipment and computers, AI is going to push it a lot higher. “AI has the potential to be the biggest productivity enhancer for the global economy since electricity,” Rizzo says. “This is an incredibly big deal, and I think it is going to change the world. Ai will be integrated into all work flows. As we saw during dot com era when productivity goes up, stocks do well.” 

That will include the Magnificent Seven. 

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned GOOGL, AMZN, AAPL, META, MSFT, NVDA, TSLA, AMD and TSM. Brush has suggested GOOGL, AMZN, AAPL, META, MSFT, NVDA, TSLA, AMD and TSM in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks

More: The ‘Magnificent Seven’ is like the ‘Nifty 50’? If only they could be so lucky.

Also read: Investors beware: ‘Magnificent Seven’ are starting to resemble ‘Nifty 50’ stocks that got crushed in the 1970s market crash