Home / Equities / Expectations matter, and the market’s ‘big fluffy toys’ have set a historically high bar: Orbis

Valuations at the top end of indexes are sky high, but with that comes inflated forecast earnings. For savvy investors, it may be time to rotate towards more value-oriented stocks according to Eric Marais from Orbis Investments.

The Magnificent Seven’s success has become an ubiquitous thematic across global markets over the last few years, and for good reason. In 2023 alone, tech giants Apple, Microsoft, Alphabet, Amazon, Meta, Tesla and Nvidia accounted for 70 per cent of the S&P’s gains alone, which represents an historic level of concentration.

For a while, in 2022, in appeared that the post-GFC cycle had turned and value stocks would take precedence. Crypto and technology stocks went off the boil and the market seemed to be equalizing once again, before the AI boom arrived and ChatGPT blew a massive gust of tailwinds into the sector.

For growth investors, or index trackers who stuck with the passive funds, the returns have been phenomenal. Valuations for these companies are now at stratospheric levels.

The question for investors, then, is whether you can make money out of stocks that are clear market leaders, yet priced accordingly.

“The ‘Magnificent Seven’ (with the exception of perhaps one or two) are proven businesses with high margins, high returns on capital, and high growth,” says Orbis Investments investment specialist Eric Marais. “So it becomes easy to dream of seemingly endless AI-driven demand for Nvidia’s chips, and the products and services the other six will build using them.”

Where valuations are concerned, expectations matter most. And expectations have never been as high as they are for this clutch of companies.

*Read Orbis Investments’ whitepaper ‘Sunrise on Venus: Investing for the Next Decade’ here.

“The market’s expectations can get ahead of even the best businesses, so that even if things turn out well, they may not turn out well enough – putting shares at risk. And with the index so unusually concentrated in the ‘Magnificent Seven’, a passive approach puts investors at risk that the weight of high expectations becomes too much to bear,” Marias said.

In a video explaining the Orbis perspective, Marais explained how the group embraces the notion that low expectations are the key to happiness. Using a claw machine with an assortment of fluffy toys to represent the slate of available companies on the stock market, he said investors may be well served avoiding the biggest prizes altogether. 

“At times like this, the big fluffy toys can look like the easy win, but it often pays to look for equally appealing opportunities that are hidden in the background waiting to be lifted out of obscurity,” he said. “When expectations are low, things don’t need to turn out great for shares to do well. Just a little better than anticipated is often enough.”

As an example, Marais compared US payment company FLEETCOR to tech giant Microsoft. 

“Looking at the basic facts of the two, FLEETCOR has stronger historical earnings per share growth and a comparable return on invested capital. So, on growth and quality dimensions, the lesser-known FLEETCOR compares pretty well to the mighty Microsoft,” he explained. “Valuation is where things differ, however. Investors have high expectations of Microsoft, resulting in a rich valuation. FLEETCOR, however, embeds low expectations, and is available at less than half the price-to-earnings ratio.”

In this case, size matters as much as expectations; after earning almost US$100 billion in operating profit in 2023, Microsoft is expected to grow 10 to 15 per cent annually. For companies of that size that reach something akin to critical mass and operate in a relatively mature market, that kind of growth is challenging. 

“On the flip side, FLEETCOR has operating profit of just below $2 billion, and it operates in a payments industry worth trillions, so it’s got lots of room to grow organically and through acquisitions,” Marais said.

“FLEETCOR represents the kind of opportunity that’s not the biggest or most eye-catching prize, but one offering real value to investors willing to dig deeper: a good company available at a reasonable price that embeds low expectations.”

It’s these kind of opportunities, Orbis believes, that represent much better value in the investment universe than the “big fluffy toys” at the top end. 

“In the world of investing, where the big enticing toys tempt us, remember: less is often more. Those unassuming opportunities that enhance your portfolio might just be the key to a winning strategy, offering the sweetest victories for those willing to look.”