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Global equity view: Looking beyond the Magnificent Seven

Growth opportunities exist far beyond mega-cap technology stocks in the ‘Magnificent Seven’. Here, we explore large cap tailwinds and a ‘peace dividend’ in Europe, as well as economic reform in Japan.

Tom O’Hara

Tom O’Hara

Portfolio Manager

Rory Stokes, CFA

Rory Stokes, CFA

Portfolio Manager

Julian McManus

Julian McManus

Portfolio Manager

Jun 18, 2024
8 minute read

Key takeaways:

  • Shifting market drivers are opening new doors for equity investors, while other areas of the market are struggling.
  • Large caps are benefiting in Europe, geopolitical tensions are sharpening the focus on defence, and Japan’s economic reforms are gathering momentum.
  • European and global equity strategies, based on strong fundamental understanding of the market drivers, provide access to compelling opportunities.

Global equities have been driven by a small number of leading companies, notably the technology giants making up the so-called Magnificent Seven. But the opportunity-set is now broadening out. Here we explore key drivers at play in Europe and Japan, as covered by portfolio managers Tom O’Hara, Rory Stokes, and Julian McManus at the recent Janus Henderson ‘Global Investment Summit’.

Big is beautiful

Large, powerful incumbents that control significant market share, strong profit margins, and healthy balance sheets have leveraged their position in recent times. This has allowed them to take advantage of favourable conditions characterised by a receding of “easy money” in the venture capital (VC) space, according to Tom O’Hara, Portfolio Manager, European Equities.

In 2023, US VC fundraising declined by 60% to hit a six-year low, according to analysis by private markets data provider PitchBook and the National Venture Capital Association. This trend also extends to Europe and is posing significant implications for the economy, particularly among fledgling businesses with dwindling cash reserves amid rising interest rates and higher costs.

“One example is within breweries where you’re seeing small craft brewers going bankrupt left, right and centre,” noted Tom. “That’s a very direct result of funding drying up as inflation has come back into the system.”

Smaller breweries have been hit particularly hard, with many having been pushed to rely on debt to finance equipment, raw materials, and in some cases, operating costs. Mounting pressures have pushed the number of business failures in the sector in the UK to increase from 35 in 2022 to 52 in 2023, according to data from accountancy firm Price Bailey.

“It’s a great time to be a big brewer with a big profit margin and a good balance sheet,” he added, noting the strong reconsolidation trend within the industry.

Large cap tailwinds

Elsewhere in the market, this receding of private capital has driven a reacceleration among larger companies to pursue bolt-on acquisitions. They were previously deterred by high fuelled by a prolonged period of low interest rates and private equity being “gung-ho” in the bidding process.

The shift in thinking is illustrated by companies including European foodservice provider Compass Group and leading lift and escalator manufacturer KONE, which are pursuing inorganic growth opportunities because valuations multiples have come down for bolt-on acquisition targets.

In May, Compass Group acquired catering company CH&CO in a deal valued at £475 million (US$604.2 million), while KONE completed its acquisition of Orbitz Elevators, an Australian-based provider of customer-designed elevator and escalator solutions for both commercial and residential properties. As Tom explained, these are just two examples of large caps having the wind in their sails.

The bigger, the better?

But while big may be beautiful, “good things also come in small packages”, highlighted Rory Stokes, Portfolio Manager, European Equities, noting that 90% of global mergers and acquisitions (M&A) transactions since 2008 have been under US$5 million in terms of market capitalisation.

“The M&A premiums that you can attract either from large corporates trying to fill holes in their portfolios or private equity firms trying to deploy capital should see significant control premiums coming through into small cap equity – it’s a really exciting time.”

Rory acknowledged that for the past three years small cap equity has lagged its large cap counterpart, with one explanation being a general anxiety that has hung over risk assets as investors waited for a global recession that never came. However, as interest rates have peaked and investor optimism has returned, Rory believes small cap equities offer strong opportunities for growth.

He also covered the private versus public route into European small caps and associated considerations for investors: “I’m always entertained by private equity managers saying they’ve got a higher quality of assets than the public markets. In fact, private equity often own companies for which there is very little transparency, typically have very bad balance sheets, and are run by myopically short-term owners,” he added.

“The analogy I would draw is that I’m as willing to believe the private equity managers that say that they’ve got a higher quality of assets, as I was prepared to believe the boys at school that definitely had a girlfriend, but she went to school across town – it’s possible, but I don’t think it’s likely.”

‘Peace dividend’ reversal

The dissolution of the Soviet Union between 1988-91 saw then US President George H. W. Bush and UK Prime Minister Margaret Thatcher coin the political slogan – peace dividend – to describe the economic benefit of a decrease in defence spending.

“When the Berlin Wall fell, American defence spending was approximately 7%+ of GDP, with it declining around 3% in the years that followed,” said O’Hara, noting that the US and Europe has entered a period of partial reversal of that trend.

The ongoing war in Ukraine and rising geopolitical tensions, as explored in our article earlier in the year ‘Investors and the new era for geopolitics,  has served as a wake-up call for nation states, particularly within the EU, that longstanding peace and stability has led to a degree of complacency on defence spending. In turn, this has rallied investors to acknowledge the to explore ethical methods to European rearmament.

“There’s clearly been a meaningful realisation with regards to European military spend,” argued Rory, who has been assessing the market to find hi-tech exposures to this theme. Further, the Russian-Ukraine war has also highlighted the vital role infantry plays in keeping European borders safeguarded.

Rory explained that Sweden-based Invisio, a global leader in tactical communications and hearing protective systems, and Netherlands-based Theon, a leading developer and manufacturer of night vison and thermal imaging systems, represent interesting market opportunities related to this theme.

‘Abenomics’ returns

Shifting the focus globally, in Japan a longstanding and persistent decline in the Yen culminating in a 34 year low versus the US Dollar at the end of May has led to action from policymakers. In response to currency weakness, lawmakers in Japan established a panel of 20 leading academics and economists to identify structural economic reforms that will address the country’s dwindling global competitiveness and divert overseas profits to boost domestic growth.

The panel is due to compile its proposals this month.

“The reforms that you’re starting to hear more about have actually been in the works for about a decade,” explained Julian McManus, Portfolio Manager in the Global Alpha Equity Team. “They started when Prime Minister Shinzo Abe introduced the corporate governance and stewardship code ten years ago.”

The incoming reforms have prompted Japanese firms to act proactively. Toyota Group has begun unwinding its cross holdings and buying back shares to make its capital structures more efficient.

“There is real change occurring on the ground in Japan,” added Julian. “Whereas last year, there was a quant trade or a beta trade, where fast money just bought everything that was trading below book value and it all levitated up to 1x book, from here there’s more opportunity for stock pickers like us to understand the stock-selective idiosyncratic opportunities.”

Japan is just one region globally where Julian is seeing compelling opportunities away from US technology, as explored in an earlier article, ‘Why investors should look beyond the Mag 7 for opportunities in AI’.

Risky business

The panel concluded by outlining the biggest risks to their respective strategies, with Tom admitting that he remains “on the fence” regarding whether the European market will continue to seek refuge in large, macro-resilient companies or if it will broaden its horizons into small and mid-cap equities.

The direction of travel, he noted, depends on whether the market receives the validation of interest rate cuts. However, upcoming elections in the US and Europe are complicating interest rate decisions by central bankers on whether, and when, to cut borrowing costs.

Building on his sentiments, Rory noted that policy error in the year ahead remained a significant concern, adding that central bankers have been late to raise interest rates and, therefore, the threat of late rate cuts remains a major risk.

Finally, Julian highlighted geopolitical risks, notably the US presidential election looming in November and the potential of punitive tariffs placed on China that may escalate another trade war between the world’s two largest economies. However, he struck a positive note to conclude that such geopolitical risks are well signposted and can be accounted for in positioning for the second half of the year.

Balance sheet: A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.

Beta trade: Refers to a trading strategy that involves taking positions in securities based on their beta, which is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Book value: Refers to the net asset value of a company, calculated by subtracting total liabilities from total assets.

Control premium: An amount that a buyer is willing to pay in excess of the fair market value of shares in order to gain a controlling ownership interest in a publicly traded company.

High Valuation Multiples: Refers to the metric used to assess the value of a company by comparing it to its peers in the industry, typically through ratios such as Price-to-Earnings (P/E), Price-to-Sales (P/S), Price-to-Book (P/B), or Enterprise Value-to-EBITDA (EV/EBITDA). When a company has high valuation multiples, it means that its price, as measured by these ratios, is high relative to its earnings, sales, book value, or EBITDA compared to other companies in the same sector or industry.

Large caps: Well-established companies with a valuation (market capitalisation) above a certain size, eg. $10 billion in the US. It can also be used as a relative term. Large-cap indices, such as the UK’s FTSE 100 or the S&P 500 in the US, track the performance of the largest publicly traded companies, rather than all stocks above a certain size.

Magnificent Seven: Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Meta and Tesla have all been dubbed the ‘Magnificent Seven’ stocks due to their outsized market capitalisations holding a disproportionate influence on the market cap weighted Nasdaq and S&P 500 indexes.

Private equity: An investment in a company that is not listed on a stock exchange. Like infrastructure investing, it tends to involve investors committing large amounts of money for long periods of time.

Profit margin: The amount by which the sales of a product or service exceeds business and production costs.

Quant trade: Refers to a trading strategy that uses quantitative analysis as the foundation for decision-making. Quantitative trading involves the use of mathematical models, statistical analysis, and algorithmic processes to identify trading opportunities and execute trades.

Venture capital funds: A type of private equity investing that typically involves investment in earlier-stage businesses that require capital, often before they have begun production or started generating revenues. Deemed a high-risk, high-reward investment it can entail greater risk of capital loss.

Janus Henderson Investors makes no representation as to whether any illustration/example mentioned in this document is now or was ever held in any portfolio. Illustrations shown are for the limited purpose of highlighting specific elements of the research process. The examples are not intended to be a recommendation to buy or sell a security, or an indication of the holdings of any portfolio or an indication of performance for the subject company.