Why I'm bearish about most of the Magnificent Seven

Stephen Yiu, fund manager of WS Blue Whale Growth, explains why he's mainly focusing on artificial intelligence (AI) infrastructure builders, as opposed to the world’s biggest technology companies that are incorporating AI into their businesses.

Yiu owns both Nvidia and Facebook-owner Meta, and has a “half position" in Microsoft, a stock he's been reducing.

In our Insider Interview, he tells funds editor Kyle Caldwell why he's not finding much value in the UK market, and explains the sub-trends he's backing within the tech sector, which accounts for around 40% of the fund.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today in the studio I have with me Stephen Yiu, manager of the Blue Whale Growth fund. Stephen, good to see you today.

So, Stephen, it's a global fund. One of the ways that investors can compare performance is to look at your performance against the MSCI World Index. Now, over the past couple of years, in 2023 and 2024, global stock market returns have been concentrated. There's been a small number of winners. In particular, the biggest US technology stocks have performed well, the so-called Magnificent Seven. Do you think in the short term there's a risk that this is a potential bubble that may pop?

Stephen Yiu, manager of the Blue Whale Growth fund: It's a very interesting question because obviously we are bottom-up stock pickers, so we only pick 25 stocks in our portfolio. If you look at the Mag Seven, we only have two stocks, just about two and a half stocks, which are NVIDIA Corp (NASDAQ:NVDA), Meta Platforms Inc Class A (NASDAQ:META), and we are reducing our position in Microsoft Corp (NASDAQ:MSFT), so I would consider that a half position.

We have probably taken a view that we don't like the other stocks, for example, Alphabet Inc Class A (NASDAQ:GOOGL), Apple Inc (NASDAQ:AAPL) or even Tesla Inc (NASDAQ:TSLA), if you consider that a Mag Seven. We have some specific concerns about those companies.

I think what has happened in the last two years or so, [is] that some of that rise, or money, that has gone into Big Tech is because of the rise of passive exchange-traded funds (ETFs). Because if you want to take a view on technology companies or AI, you just want to buy a basket of stocks, right? And obviously a lot of the baskets of stocks would encompass some of these very large companies per se. So, I think that's a lot of money that's gone into names that we do not think is justified and, of course, sometimes it puzzles us.

For example, Alphabet. I still have a very negative view in terms of the growth trajectory from here on the back of generative AI is going to be a disruptor to its business model. But, of course, you look at the share price, it has still done very well. So, then, who is right? Is that the market or maybe us?

I don't disagree with you that at some point there's going to be some shake-out in terms of exactly what AI means. And of course, we took the view that we are more pro-AI infrastructure versus AI applications. If you look at a Mag Seven, bar Nvidia, all of them would be an AI applications company rather than AI infrastructure. So, I think in time we will be able to see which narrative is correct.

Kyle Caldwell: So, let's talk through the two positions you still have plenty of conviction in. Do their current valuations reflect the future earnings potential, or in other words, are you comfortable with the current valuations?

Stephen Yiu: I think they are very different businesses, so I need to probably expand a little bit.

I think the interesting thing about Nvidia is a lot of people probably who haven't done the work on Nvidia would be saying, Nvidia is trading in bubbly territory. Looking at the share price, how is it possible a company would have gone up 200% or 300% over a short space of time?

But if you look at the earnings that Nvidia has delivered in the last two, three years, that has gone up even higher, so compared to the time when we first invested into Nvidia in 2021, while Nvidia's market cap was only at about $500 billion, the valuation at the time was a lot more expensive than it is today.

Nvidia today, even at the $3.5 trillion market cap, is a lot cheaper compared to 2021. So, this is something to note, that the valuation that Nvidia's trading at, let's say using 12-month consensus number, is only over 30-35x, just about. And what 30-ish x earnings means is, if you look at Apple, Apple doesn't grow 50% to 100%. Apple's valuation is at about 30x earnings. But what it means is, because Apple's business is relatively sticky in terms of the customer base, the ecosystem, it means that the quality would then reflect some of the valuation. This is something that I would expect Nvidia to trend towards.

So in time, Nvidia does not need to repeat the growth trajectory they have delivered in the last two or three years. Going into the next couple of years, they just need to deliver some healthy growth, which is something that we believe in. I think the market valuation already reflects that today, because the valuation of Nvidia is only trading at over 30x earnings.

On the other hand, Meta, we do like. I think if you ask me to pick one AI applications company that is going to be the ultimate winner, or at least have the highest potential to deliver return on investment for shareholders, we would pick Meta just because the majority of that investment is going into that internal workflow. They are probably going to analyse our data a lot more through Instagram, Facebook, maybe, a bit of WhatsApp. It's quite controversial.

I think in time they will be able to deliver personalised advertisements. So, in terms of return on investment, because they're very data heavy, they have like three billion users in the world, so 50% of the world's population, that's going to be very interesting. If you think about what generative AI means, it's all about data.

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Kyle Caldwell: The fund has around 40 to 45% in technology. Could you break down that exposure? I know there are certain companies you own that you think could be classified in another sector.

Stephen Yiu: So this is interesting. If I go back in time, so on average over the last seven years or so, we have had 40% exposure to technology companies. But what has been interesting is that the composition of that mix is completely different today versus seven years ago.

Seven years ago, we were heavily exposed to digital transformation opportunities like digital advertising, software, digital payments, cloud and some others, and today it's mostly AI. But the one bit that is very debateable and, of course, we would have a slightly different view, but at the moment is categorised in the technology bucket, is semiconductor equipment companies.

We like both Applied Materials Inc (NASDAQ:AMAT) and Lam Research Corp (NASDAQ:LRCX), so very similar to ASML Holding NV (EURONEXT:ASML), which we used to own but no longer have today. They are the picks and shovels in terms of how the world operates on a day-to-day basis, right?

If you need semiconductors, which are in almost every device that we can get our hands on today, then you need that semiconductor to be produced, but using some of this equipment. So, all this equipment will go into the foundries to produce semiconductors. Then, if you think about exactly what that is, it means that they're probably more of an industrial company rather than a technology company.

Of course, a lot of things are technology. But could we actually separate technology from our day-to-day today? You can't do that anymore. It's not just from a consumer perspective, at the same time, from businesses' perspective, or even if you are industrial businesses, you would have a lot of technology, the robots, the automation, in that. So, you can easily categorise semiconductor equipment companies as 'industrials' rather than 'technology'.

That is something that we're not worried about, but it might be a bit misleading when you look at technology, [and think] 'oh that's a lot', and then we haven't probably got enough of industrials, which some other managers might have.

Kyle Caldwell: Do you think about the overall exposure? You’ve mentioned some companies could be classed as in other sectors rather than technology, but given you have around 40-45% in technology, is there like an upper limit that you think, actually I want to go higher than that?

Stephen Yiu: I think we are very pragmatic on that. I think the way we run the fund is that we want to invest into the best companies that can outperform over the next coming years. So far, where you find those companies would be mostly in the technology bucket, right?

You would struggle, I think, most active managers would struggle, if you decided that, you did not want to have technology in your fund, or you have a very small exposure in the fund, or you think maybe the likes of consumer staples are going to do better than a Mag Seven. I think that is probably a detrimental mistake that you can make.

Also, I think people need to acknowledge that maybe just over seven years ago, the technology component of the market would be probably less than 20% because the market cap of Microsoft was only at about $500 billion. Today, it's $3 trillion, and then you've got a few more that are in the trillions' bucket, right? The Mag Seven.

If you look at the composition of the index, which is something that as an active manager we need to outperform, part of the passive, you need to take into account the composition of the index. At the moment, you will probably say that we are just about in line with the market because the technology component of the market has got a lot bigger over time.

Of course, I mean that's not how we manage money, but is that a stopping point? We don't know because if this continues, if AI is really going to change the world, then I think that certain businesses are going to disappear on the back of that.

It's similar to how digital transformation has taken place in terms of killing a lot of high street retailers. We are now spending a lot more time in the digital world versus the physical world before the pandemic. So, that could be a similar repeat of that in a very different trajectory. You need to be very careful as an investor to pick the right sectors or companies that will do well under this new era.

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Kyle Caldwell: Given that you can invest globally, is the UK a stock market interesting you at the moment in terms of the investment opportunities? A lot of commentators have been talking up the UK market due to the fact that it's trading on lower valuations than its history and the share prices are cheaper than other markets such as the US. Do you have any exposure to the UK?

Stephen Yiu: We have some. We started off with Flutter Entertainment (LSE:FLTR), it was a UK company, and they have now re-headquartered to the US, so they're going to drop out of the FTSE index.

We like Flutter in terms of the US sports gaming market, and at the same time we have a very small position, or we are trying to build conviction in London Stock Exchange Group (LSE:LSEG). Data is part of their business after they acquired Refinitive a few years ago, so 50% of the business is in data analytics and the terminals.

If you look at the IPO of the London Stock Exchange business itself, it's only like 5% of the business. We need to see how this is going to play out because they are adopting certain AI technology, and working with Microsoft to enhance some of their capabilities.

I think the way that investors should think about how to allocate money, whether that's to UK companies, American companies or Asian companies, is to ask yourself what your objective is. Our objective here is to maximise the outperformance potential, we are trying to maximise your investment return.

The UK is very undervalued. It has been undervalued for, I don't know how many years. I started off my career as a UK fund manager. You can talk about different strategies, a growth strategy, value strategy, a quality strategy, but it doesn't really matter because, ultimately, if you believe UK companies can maximise your returns, you buy UK companies.

That's not our view. Our view is we want to buy American technology companies, thus maximising the return potential. And that's how we have managed to recover quite strongly on the back of 2022 over the last two years. I don't think we can do that investing into UK companies. But, of course, things can change.

I think you need to be quite open-minded when things are developing, and obviously we welcome more opportunity in the UK. But at the moment, I think it's a lot more difficult to find companies that could be exposed to certain mega-trends, which is [when] you are going to become a lot bigger than before.

The last point I would make is, if you just use Nvidia as a proxy, two years ago they were only making about $30 billion top line and this year they're making $150 billion, as one single company. If you think about the NHS in the UK, the budget's about £100 billion, and we are all short of money. But then you have this company suddenly coming from nowhere and they're making $120 billion more today. So, you want to invest in this kind of company rather than some company [where] there’s just not a lot of growth opportunity.

Kyle Caldwell: Finally, we always ask whether fund managers have skin in the game. But it's a question I've asked you before, so I'll slightly rephrase it and ask, do you regularly invest in your own fund?

Stephen Yiu: From my perspective, I only invest in the Blue Whale Growth fund because I run it. I have an inside track, I have more conviction than most other people from the outside, and I don't invest in other funds. So, that is what I have done for myself.

In terms of ongoing investment, the Blue Whale Capital Partnership, so the company itself, decided to invest about £120,000 a year into the fund strategy. We started that exercise back in 2022, and in 2022, of course, that's a valuation reset in terms of the NAV, the valuation, and then what we did at the time was decide to spread out that investment across a 12-month period through like a pound-cost averaging exercise. So, £10,000 a month over that 12-month period until last year, and that strategy has done very well for us. Now the profit is up more than 50% based on our average price into that 12-month period.

This year, what we have done with an additional £120,000 is seize the opportunity during the summer. That was a bit of a reset in the market in terms of our holdings in valuation terms. So, we have invested another £120,000 over the summer this year as 2024 investment. Of course, if you follow the exercise, which we have done on our factsheet on our website, that investment has also gone up a few per cent over the last few months already.

Next year, we're going to do it again. So, this is like an ongoing commitment just to take investors' hands through the journey, like how you can deploy capital, and different strategies work at different times, and, of course, you can do an ongoing monthly contribution. But at some point you may want to deploy more capital just because you get a better price in terms of what happened in the market that's not related to the company fundamentals.

Kyle Caldwell: Stephen, thank you for your time today. That's it for our latest Insider Interview. I hope you've enjoyed it. You can let us know what you think, you can comment, and if you liked the video hit that like button and you can also hit the subscribe button for more future fund manager videos. Hopefully, I'll see you again next time.