The concept of too big to fail refers to certain financial institutions, typically large banks, or financial firms whose collapse could trigger widespread financial instability, are deemed so integral to the functioning of the economy that their failure would have catastrophic consequences.
Governments often intervene to prevent their failure, using measures such as bailout or regulatory protections.
However, the economic landscape is rapidly changing and these institutions are not necessarily in the financial sector but also in other sectors like the technology sector.
For instance, a widespread and prolonged outage of internet infrastructure, whether due to a natural disaster, cyber attack, or technical malfunction, could severely disrupt global commerce, communication and financial transactions. This would impact businesses’ ability to operate, disrupt supply chains, and hinder economic activity across various sectors.
Other technology failures that would severely impact the global economy include failure of global positioning systems (GPS) which are integral to transportation, logistics, telecommunications, agriculture and food security among others, as well as the collapse of digital payment systems, the energy grid and cyber security breaches to mention but a few.
Among the global technology counters, a few have stood out recently, earning the title of “the magnificent 7”. These are software company Microsoft, semiconductor counter Nvidia, electronics company Apple, online retailer Amazon, social media platform company Meta, Google parent Alphabet and electric vehicle manufacturer Tesla.
Despite the simplistic definitions these companies are involved in a wide range of activities including cloud services, advanced security solutions, financial services and payment systems, artificial intelligence, the internet of things, big data, augmented and virtual reality, telecommunications and mobile operating systems, clean energy, battery storage, electric grid networks and the list goes on. All of these are integral to the functioning of our society and economy as we have come to know it.
This has been evident in the dominance that they have had not only within the technology sector, but also in US and global markets. Last year alone, these seven companies accounted for about 50% investment returns on the S&P 500 in the US. They are now larger than UK, Chinese, French and Japanese markets combined by MSCI world index weighting, larger than gold by market capitalisation and account for about 60% of the next 12 months’ earnings growth expectation in the US.
This has resulted in high levels of market concentration and stock specific risks not only in US markets but also global markets. The individual performance of each of these companies will have a strong influence on overall market performance, and the inclusion or exclusion of these counters in investment portfolios will result in big deviances in investor returns.
Good investment cases?
But are these good investment cases? Of these, we are invested in four of them in our direct share portfolios: Microsoft, Amazon, Apple and Alphabet. These have all beat revenue and earnings consensus estimates, each growing their earnings by double digits on a year-on-year basis on their latest earnings release.
Though expensive in absolute terms, this valuation is justified by their forward earnings growth expectations, brand power, economies of scale, network effects, barriers to entry and switching costs for consumers who have been locked in. Furthermore, relative to their own historic valuations Amazon is actually slightly cheap while Alphabet is more or less in-line.
Apple has continued to see an increase in mobile phone revenue, while Microsoft has seen positive price revisions, high upside potential, increasing forward revenue estimates and increased revenue from infrastructure. Alphabet has also seen increasing revenue estimates, increased advertising revenue and has high operating margins relative to its competitors. Amazon has improving operating margin relative to its own history, increased online marketplace revenue and high sales growth expectations relative to competitors.
These companies are not without their own individual risks but do make for a compelling investment case. With the recent rallies, we are concerned about short-term volatility and pullbacks, and as a result have taken a bit of profit off the table. However, we remain long-term investors despite the short-term volatility.
On Nvidia, we have opted to invest in their competitor Micron, which offers similar upside potential and participation in the semiconductor space, while having more attractive valuations. However, on Meta and in particular Tesla, our main concern has been around governance structures and sustainability.
Meta embarked on a quest to develop the Metaverse with extensive capital expenditure and no end in sight, destroying shareholder value in the process with multiple senior executives resigning from the company. Though CEO Mark Zuckerberg has turned to be more profit conscious, which has resulted in share price rallies, we continue to monitor this closely as a repeat of previous activities could similarly destroy shareholder value without a proper governance structure in place.
Notwithstanding Elon Musk stepping down from being chair of Tesla, he is still a board member in addition to his CEO role, with unprecedented power and authority over the company which gives us governance concerns. Furthermore, the company has experienced decreasing revenue estimates, debt maturities approaching and decreasing sales growth expectations.
A big difference with these technology companies is that governments often do not understand them, and their challenges are not easily solvable by money and bailouts particularly if they are of a technical nature. Thus their individual collapse would not be removed from the realm of possibility. It is therefore crucial to continue investing in the higher quality counters within this innovative space.
• Smith is chief investment officer at Absa Global Investment Solutions, Stockbrokers & Portfolio Management.
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