The M7 Takes Over the S&P 500

Inflation rears its ugly head again

Just as the Fed recently kept interest rates steady, taking the prudent course, inflation rose 3.0% in January YOY from 2024, with a 0.5% increase in January alone. Part of that was driven by companies who have raised prices to get ahead of the proposed Trump tariffs.

Higher prices could prove problematic in 2025, as consumers reduce spending, which historically can, in turn, trigger a broader recession as aggregate demand diminishes.

Unprecedented market concentration

The proportion that the “Magnificent 7” stocks make up in the S&P 500 has reached historical levels. Experts debate whether this is inherently a good or bad thing for investors, but we tend to agree with Goldman Sachs Chief Equity Strategist David Kostin.

“History suggests that high concentration is associated with lower returns over longer horizons. Specifically, when Kostin adds in market concentration as a distinct variable to his long-run return model, the model forecasts average S&P 500 annualized returns of 3%—sharply below the historical average of 11% and 400bp below the 7% average that the model excluding market concentration would suggest.”

As value investors, we should not only avoid specific names among this group that may have already seen their runs overextended but also avoid mutual funds or ETFs, as we discussed last week, which could experience a drag in the coming 5-10 years if these mega-cap stocks flatline or decline sharply.

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GOOG

Alphabet should be on every investor’s watchlist.

We just discussed how the market cap of the M7 is at historic proportions of the S&P500, so you may be wondering why we would want to avoid the M7, sans Alphabet. The answer is twofold:

Firstly, its valuation relative to its future earnings is not that bad; in fact, it could arguably be the only member of the M7 that is NOT very overvalued or perhaps undervalued at a PE ratio of ~24, only slightly higher than the 17 mean PE Shiller Ratio of the entire market’s history. The company produced a 18.3% revenue CAGR over ten years, which has slowed to 16.8% over the past five years, but still phenomenal growth. Additionally, it’s Cloud business grew 30% and is expected to grow faster still with more capacity coming online in 2025. Additionally, the company issued its first dividend in 2024 and simultaneously committed $70B in share repurchases. We expect this return of capital to shareholders to continue in the coming years as Microsoft began to do in 2003.

Secondly, its economic moat — its ability to continue to generate cashflows based on its businesses — is vast. While it’s true that Alphabet’s share of online advertising revenue is shifting downward in percentage terms, it is still likely to remain the number one platform for online advertising for the foreseeable future and as the overall share of advertising dollars grows over time, Alphabet will continue to dominate that space and capture outsized growth and returns.

In addition to its dominance in the ad space, Alphabet has been slowly diversifying its revenue base through acquisitions of adjacent businesses in health (Fitbit), home automation (Nest), and cybersecurity (Mandiant). With a robust offering to businesses and everyday consumers, we are bullish on Alphabet’s long-term prospects and believe the firm is the only member of the M7 that can overcome the headwinds facing each of those business models in the coming years.

Depending on how you calculate their future cashflows, Alphabet could be an undervalued company today. Alternatively, if you are anticipating a broader market pullback in 2025, determine your entry price and keep GOOG on your watchlist.

Disclosure: TEI has a long position in GOOG

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_{Legal Disclaimer: The Evolved Investor is for information purposes only and is, by law, not personal investment advice. Concepts and ideas are for your consideration only. We encourage our readers to do their due diligence. Investing has inherent risk, and investments can lose value.}