Emerging market leaders: beyond tech giants

In the story of the equity market’s remarkable run, the Magnificent 7 tech titans have played a starring role. The narrative that surrounds them is a seductive one. Together, Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla have accounted for close to 50% of the S&P 500 index’s total gains over the past three years.

On closer inspection, however, it is not altogether clear that Silicon Valley’s finest ever were – or will be – the only leading protagonists.

There are two other cohorts of stocks that have had – and promise to continue having – a significant bearing on the returns of equity markets.

The groups in question are the Terrific 20, a collection of mega caps whose share price performance has matched that of the Magnificent 7 over the last five years, and the Forgotten 50 which, as the label suggests, is an assortment of highly profitable firms that have curiously fallen out of favor.

Both merit scrutiny, albeit for different reasons.

Take the Terrific 20 first.

The stock returns generated by this group – mega cap firms operating not just in technology but across a broad array of industries from consumer and financials to industrials and energy – have eclipsed those of the Magnificent 7 by some 12% so far this year.

Their continued rally is the main reason why valuations for the S&P 500 index have in aggregate scaled the cyclical high of 23 times earnings following the inflation-inspired sell off of 2022. At first glance, this is a positive development. It suggests the US market’s rally is now on a much firmer footing, extending beyond Nvidia, Microsoft and the five other tech behemoths.

Dig deeper, however, and a different picture emerges.

There is a worrying snag to the Terrific 20’s exceptional run. Their share price gains haven’t been accompanied by an improvement in their earnings.

Although US firms are significantly more profitable than they have been historically – return on equity for the S&P 500 is presently running at 19% versus a long-term average of 15% – high equity valuations tend to reflect expectations for either pickup in profit growth or sustained profitability with ever greater increases in revenue. And on these measures, the Terrific 20 have not delivered – at least, not yet.

In contrast to their magnificent peers, whose share price gains have been matched by extraordinary profit growth, the Terrific 20’s earnings have so far been unremarkable.

While their stock valuations have climbed by 60% in just two years, their contribution to the S&P 500’s total profits has fallen to 15% from almost 20% a decade ago.

What is more, consensus analyst expectations for the Terrific 20’s earnings have risen by 15% per year since 2020, only marginally ahead of the overall market but well below the Magnificent 7’s 26%. All of which has broader implications for equity investors.

The Terrific 20’s surge means a considerable portion of the S&P 500 index is trading at levels that are at odds with companies’ proven earnings delivery.

According to our calculations, firms accounting for two thirds of the index’s market capitalisation now trade at price-earnings multiples of 25 times compared to less than a third just two years ago.

In other words, there is a growing number of stocks that command elevated valuations in the hope of a sustained improvement in business fundamentals that has yet to materialise. That leaves US equities much more vulnerable should the economy stall.

Yet this doesn’t necessarily mean equity investors should retrench wholesale from the US. It may be that a rotation is about to unfold, a process through which one group of richly valued stocks hands the market leadership baton over to a collection of unjustifiably cheap ones.

Indeed, for every Terrific 20 company that has seen its valuation soar, there are at least two stocks that have experienced the exact opposite. Enter the Forgotten 50: the cohort with the potential to become the market leaders of tomorrow.

Equivalent to approximately 5% of the S&P 500 index’s market cap, these companies have seen their earnings multiples fall to just two thirds of their 10-year average. That correction began as a response to overly optimistic growth forecasts, but now looks to have gone too far, particularly when measured against the near 200% increase in these firms’ profits over the last five years (Fig. 3).

The group is hardly an unknown quantity, either. It consists of hugely successful firms – most of which are part of a ‘quality’ cohort of equities – that include e-commerce group Mercado Libre, customer relations software provider HubSpot and pharmaceutical giant Eli Lilly (see box).

Such high-quality stocks have endured near unprecedented levels of underperformance relative to the broader market, in part because the economy has so far confounded expectations of a slowdown despite considerable geopolitical upheaval and trade disruption. Interestingly, the same trend has also taken hold in Europe.

With markets having taken a leap of faith – on growth, on inflation, and on the continued credibility of US institutions – the margin of safety for equity investors is low. By the same token, though, it is also a favorable backrop for quality stocks – those with a track record of steady earnings, high profitability and low leverage – such as those that are among the Forgotten 50.

Moreover, ‘quality’ tends to be a low beta equity style which holds its value in the event of a broad market sell off while still retaining exposure to positive long-term structural trends.

In our view there are several reasons why investors can expect these stocks to outperform over the medium term. The macroeconomic case is particularly strong. Quality stocks tend to fare especially well when economic growth is moderate. And according to our forecasts, US GDP growth will slow to a rate that is some distance below its long-term potential. We expect just 1.3% US GDP growth next year, well below the consensus estimate of 1.8%. Moreover, our models show inflation could also run ahead of what is currently discounted by bond markets.

Valuations are favorable. With the share price performance of quality stocks having lagged that of mega-caps by an unusually wide margin over the past few years, the valuation premium demanded for reliable earnings generation is now in line with the long-term average.

This is not to suggest that the Magnificent 7 will disappear from investors' radar screens, given their dominant position in their respective industries and the crucial part many of them play in the build out of AI infrastructure. If anything, the valuation premium they trade at relative to the rest of the market is close to the lower end of the range in the AI era, suggesting they should continue delivering decent returns.

Yet for investors trying to fathom how US equities might fare from here, there are a few practical considerations to draw from our analysis.

To begin with, by looking beyond the handful of  mega cap tech stocks that dominate the headlines, there are significant share price shifts beneath the surface that sharp-eyed investors could benefit from. Many mega cap stocks that have been responsible for the market’s stellar performance are becoming very expensive.

While this might not yet fully apply to Magnificent 7, the 20 other stocks that have quietly risen up the S&P 500 leaderboard in recent months merit scrutiny. Investors with a longer time horizon should begin to diversify away from US mega caps, a strategy that would offer insurance against both a market correction and the emergence of a new set of leaders.

This would mean allocating more capital to mid-cap stocks, which we believe represent the next generation of winners, as well as adding to non-US champions. An alternative – or complementary – approach would be to re-allocate capital to good quality companies whose shares are undervalued.

There are plenty of those – many of which among the Forgotten 50. These could be market’s new champions once some of the mega caps begin to ride out into the sunset.