Why the best stories often don't make good investments

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A handful of global companies have provided outsized returns this year, creating both risks and opportunities. Sometimes, the best businesses don't make the best investment cases.

Markets have been hostile this year. There has been a material increase in the cost of capital on the back of the rapid rise in interest rates globally. We have also seen an extreme narrowness of the market. Investors have grown accustomed to the fact that technology has become a dominant driver. A handful of companies have provided outsized returns this year, largely generated by the Magnificent 7 - Apple, Microsoft, Alphabet (Google), Tesla, Amazon, Nvidia and Meta (Facebook). A lot has been written about these goliaths and their link to the hype surrounding artificial intelligence and the way in which it will change everything.

While the market is up 10% this year, nearly two-thirds of that total return is directly attributable to these seven stocks, up on average by 84%. Owning anything outside of these names, therefore, has been a challenge for many portfolios.

Artificial intelligence or artificial valuation?

Most of the top performers' returns have come from a rerating, with the result that investors are paying more for the prospective expectations of returns rather than the actual earnings growth they have delivered, even though the earnings for those stocks are up an impressive 31% on average. These shares have, therefore, become more expensive in the context of the broader market. Simply measured on a forward price/earnings basis, they are 40% more expensive than they were at the start of the year. If that is the case, you must be confident that the growth is going to come through. However, it is hard to see how trillion dollar-plus market cap companies will be able to compound at the same rates of return they have done historically. How much revenue are they going to have to continue to generate when the starting point is more than $100 billion dollars a year?