Through the third quarter of the year, it may be easy to forget that the market was solely focused on whether we were about to enter a central bank-induced recession. Instead, coming off the worst year for the S&P 500 since 2008, the market has shrugged off rising rates, inflationary headwinds and the lackadaisical corporate revenue and earnings growth to deliver strong returns.
In particular, a small subset of stocks, colloquially known as “the Magnificent Seven”[1] have contributed the lion’s share of the index’s returns this year. After a challenging year for technology stocks and the enthusiasm for all things AI, we can appreciate why investors are hungry for the extravagant revenue and earnings growth numbers these businesses have delivered. We have previously discussed how we believe we’re responsibly investing in companies that are poised to benefit from the long-term secular growth trends due to the significant investments being made in Artificial Intelligence.
Given the spotlight on these companies, however, it is prudent to emphasize that their valuation multiples have adjusted accordingly:
Exhibit 1: Revenue and EPS Growth and Change in P/E from Q4 2022 to Q2 2023
As bottom-up investors we are required to look to the future when evaluating potential investments with our client’s capital. Too often when companies trade at lofty valuations it is due to, at best, overly optimistic and, at worst, unrealistic projections for future growth. While not bargain hunters, our approach focuses on being confident that we don’t overpay for a business. We keep in mind the old investing adage that a great business can be a poor investment if you pay too much for it.
In our view, despite their impressive short-term growth trajectories, the current valuations for some of these companies leave little room for error. Any speedbump in delivering on those rosy growth assumptions represents significant risk. In contrast, we feel our US Equity strategy is much more reasonably priced while delivering vastly superior revenue and earnings growth relative to the market – with fundamental results that are in line with the Magnificent Seven.
Exhibit 2: Median Revenue and EPS Growth
Source: Bristol Gate Capital Partners, Bloomberg. As at August 30, 2023.
Every so often, a few companies are given the limelight and become market darlings, but it is rare they can live up to the height of their expectations. Opportunities for long-term investors are those businesses that are being ignored by the masses. Our focus on high dividend growth companies leads us into high quality, growing businesses without nosebleed valuations. For any investor, paying for growth is unavoidable, but why not pay less?
[1] Magnificent Seven Stocks: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
Important Disclosures
There is a risk of loss inherent in any investment; past performance is not indicative of future results. Prospective and existing investors in Bristol Gate’s pooled funds or ETF funds should refer to the fund’s offering documents which outline the risk factors associated with a decision to invest. Separately managed account clients should refer to disclosure documents provided which outline risks of investing. Pursuant to SEC regulations, a description of risks associated with Bristol Gate’s strategies is also contained in Bristol Gate’s Form ADV Part 2A located at www.bristolgate.com/regulatory-documents.
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