The magnificent 19,000 (and counting)

I suspect the so-called magnificent seven needs little introduction but on the off chance you’ve been living off-grid on a remote desert island, the phrase was coined to describe the select group of US mega-caps dominating both column inches and returns.

Providing some context for the younger amongst us, the moniker is a nod to the 1960 American Western where seven gunslingers “fight like seven hundred” to defend a Mexican village from marauding bandits.

It’s not entirely clear who’s being cast as the bad guys (possibly The Fed for ‘higher for longer’ interest rates?) but macroeconomic and geopolitical issues have undoubtedly been casting their gloom over equities on both sides of the Atlantic.

Enter the magnificent seven who have certainly been fighting for the other 493 companies in the S&P 500 as far as returns are concerned. They delivered a total return of more than 110% in 2023, compared to just 13% for the equal-weighted S&P 500 Index. Though it’s worth mentioning that the lion’s share of the seven’s gains would have only returned investors back to break-even after their negative return of more than 45% in 2022.

Reaching tipping point

The superior performance of this group has led to the highest concentration in US equities in the last 60 years, according to JP Morgan. Putting this into context, the market cap of the magnificent seven exceeds the entire value of the UK, Japanese and Canadian stock markets combined and Microsoft alone isn’t far off surpassing the value of the FTSE All-Share Index.

This may be food for thought for investors buying US or global index-tracking funds as a ready-made diversified portfolio of equities. But the more pressing question is whether this level of concentration and outperformance is sustainable or is it reaching tipping point?

The chart below shows the relative returns of the equal-weighted versus capitalisation-weighted S&P 500 indices, with a positive number indicating the percentage points by which the equal-weighted index has outperformed (and a negative number where the capitalisation-weighted index has outperformed).

Overall, the equal-weighted index outperformed in more than half of the last 25 years and this outperformance was as high as 17% in the year following a year of relative underperformance. These periods of outperformance have tended to follow periods of peak concentration, such as the six consecutive years of outperformance in the early 2000s.

While past performance isn’t a guarantee of future performance, investors looking to diversify their portfolio beyond an increasingly mono-thematic exposure to the magnificent seven may reap the rewards if (or when) this concentration unwinds.

Expanding the universe

The magnificent seven may have dominated the financial press but publicly-listed companies account for only a small slice of corporate America, with the number of publicly-held companies halving over the last 25 years.

As the chart below shows, almost 90% of US companies are private, with higher numbers of private than public companies in all categories, including the largest companies with $1bn plus revenues. This demonstrates the maturity of private markets as companies are choosing to stay ‘private for longer’ in part due to improved access to financing and the lower burden of regulatory compliance.

As a result, investors have turned to the private equity sector for exposure to the rich vein of high-growth, dynamic companies within the private market, with global private equity assets passing the $5trn mark in 2023, according to EY.

To put this into context, The Atlantic reported that private equity firms managed around 4% of total US corporate equity in 2000 but this had soared to almost 20% by 2021.

NB Private Equity Partners (NBPE) looks to generate attractive long-term returns by investing in a carefully-selected portfolio private companies (currently 85) across a wide range of sectors, market cap and (by co-investing) alongside over 50 third party private equity managers.

Around three-quarters of the portfolio is currently invested in North America, with Europe accounting for the majority of the remainder. This provides exposure to many of the trends that have been powering the magnificent seven (amongst others).

One sector with strong secular growth trends represented in NBPE’s portfolio is e-commerce, which globally is forecast to grow by 10% a year to reach $6.5trn by 2029, according to Statista. One portfolio company example within this sector is Auctane, in which NBPE invested in 2021 as part of a take-private transaction. Auctane is a leading provider of shipping software solutions for consumers and businesses, including discounted carrier rates with partners such as UPS.

Auctane software was used for 3.5 billion of shipped packages in 2020, representing 5% and 15% of global and US e-commerce respectively by value. The company continues to deliver strong growth as a private company away from the glare of public markets, and recently acquired Return Rabbit to strengthen its returns management offering.

NBPE balances its portfolio exposure to long-term structural growth drivers such as e-commerce with investments in companies with low expected cyclicality, in order to manage downside risk for investors.

One such example is their co-investment alongside KKR in USI, a leading provider of insurance and employee benefit consulting and brokerage services to middle-market clients across the US. NBPE was attracted by the favourable industry dynamics, due to the non-discretionary nature of USI’s services and the opportunity for consolidation in a highly-fragmented industry.

Superior growth potential

Returning to the magnificent seven, superior earnings growth has been a key driver of their share price returns, as demonstrated in the chart below. They have delivered an average annual growth rate of around 9% in both revenue and EBITDA in the last calendar year, comfortably exceeding the 4-5% growth rates of the broader S&P 500 and MSCI World indices.

Over this period, private companies in NBPE’s portfolio delivered significantly higher weighted average growth of more than 11% and 15% in revenue and EBITDA respectively. Indeed, the top 30 private companies achieved EBITDA growth of more than 18%, almost double that of the average for the magnificent seven.

This is testament to the superior growth potential in private markets and Neuberger Berman’s investment selection process, allowing for longer-term investment views to be taken without underlying companies having the pressure of meeting quarterly earnings forecasts.

Turning to valuation, the weighted average EV/EBITDA multiple for NBPE’s private company portfolio is 14.9x (as at 31/12/2023, based on 65 private companies). Whilst publicly-listed companies typically trade at a premium to their private counterparts, this valuation is below the 15.6x and 22.7x EV/EBITDA multiples for the S&P 500 and Bloomberg Magnificent Seven indices (as at 24/06/2024), despite their superior growth rates.

Investors may understandably have some concerns about the valuation of private companies, which isn’t as straightforward as publicly-listed companies. However, evidence for conservatism in private equity valuations in general can be seen in the valuation uplifts when portfolio companies are sold (as discussed in our recent article), and we highlight that NBPE has a five-year average uplift of 37% in company valuations on exit.

Overall, NBPE has delivered an impressive five-year net asset value total return of 74% (as at 24/06/2024) and is currently trading on a discount of c. 26%.

We’ll end with a final word on the Magnificent Seven for the uninitiated. The villagers, newly-trained in weaponry by the seven, claim victory against the bandits but sadly only three of the original seven live to tell the tale. A salutary lesson for investors, if ever there was one, of the dangers of risking it all on the fortunes of a few.

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