Michael Brush: 3 reasons it’s safe to own the ‘Magnificent Seven’ stocks

Many stock market commentators turn reflexively negative on groups of stocks just because they do well. Naturally, the “Magnificent Seven” stocks land squarely in their sights. They say you should avoid these stocks or even consider shorting them.  Here are three reasons why the skeptics are wrong about Alphabet
GOOGL,
-2.47%,
Amazon.com
AMZN,
-1.51%,
Apple
AAPL,
-1.55%,
Meta Platforms
META,
-2.03%,
Microsoft
MSFT,
-1.80%,
Nvidia
NVDA,
-2.82%
and Tesla
TSLA,
-0.88%
— the Magnificent 7. 

1. The “rich” valuations are entirely justified: The most common knock on the Magnificent Seven is that they are “overvalued.” On the surface, this argument seems valid. These stocks’ p/e ratios appear high. Recently their average forward p/e was close to 35, more than twice the long-term average p/e of 16.5 for the S&P 500
SPX,
and a p/e of 15.6 for this index if you take out the Magnificent 7.  But what if those elevated p/e ratios are justified? That’s actually the case, says Tim Murray, the capital markets strategist at T. Rowe Price. “The outlier valuations that these stocks carry is absolutely matched by the fundamentals,” says Murray, who is otherwise cautious on the stock market in part because of what he believes is the potential for a U.S. recession.  Here’s Murray’s logic on the Magnificent Seven. The starting point is that Murray thinks return on equity (ROE) is a good one-size-fits-all metric for capturing the fundamental strength at companies. ROE is defined as net income divided by total equity. It is a basic measure of how well managers are running a company. “The Magnificent Seven have outlier valuations, but the ROE, the fundamentals, are every bit as much of an outlier,” he says.  He puts the average ROE for the Magnificent Seven at 33%. That’s twice the ROE for the U.S. stock market, which is 16.47%, according to NYU Stern School of Business finance professor Aswath Damodaran. While ROEs vary by sector, in general an ROE of 15% to 20% is considered good. Many of the Magnificent Seven are way above that. At Nvidia, for example, the ROE is 40.2% while Microsoft has an ROE of 39.1%.  “What that’s telling you is you shouldn’t just expect the valuations to come down because of gravity,” says Murray. “The reason they would come down would be if they are unable to sustain those fundamentals.”  2. The AI trend is their friend: The Magnificent Seven should be able to sustain their fundamentals because they all have exposure in one way or another to the big tech trends — including the biggest one of all: artificial intelligence (AI).  “Their ROEs will stay at least at these levels or expand from here because these are the companies best positioned for AI and this incredible revolution,” says Dom Rizzo, a technology portfolio manager at T. Rowe Price. The most obvious direct beneficiary is Nvidia, since it sells chips, software and related gear that’s crucial to the computer processing that powers AI, Rizzo says. Its H100 chips (and the B100 to launch next year), CUDA software, and Mellanox networking and switch technology power AI infrastructure in the cloud.  “Nvidia has the full portfolio solution,” he says. Nvidia beat estimates and raised earnings guidance so much this year the stock has actually gotten cheaper, Rizzo adds. Read: H …

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