The Magnificent 7 and the Dangers of Market Hype
I am back from Italy. My brother Alex, my son Jonah, and I attended a value seminar in Trani, located on the Adriatic coast in Puglia. After the conference we flew to Pisa. I just want to let you know — there is a tower there that is still leaning. Looking at the tower and seeing tourists swarming it, I could not stop thinking that if they had fixed the leaning issue nine centuries ago, these tourists (including yours truly) would have been swarming the streets of another small Italian town instead.
Our last destination was Florence. The last time I was in Florence was Christmas of 2000, when my wife was pregnant with Jonah. So technically, this is Jonah’s second time visiting Florence. I remember our first visit as if it were yesterday: It was rainy and cold, and everything was closed, including restaurants. Following a long-standing American Jewish tradition, my wife and I had Christmas dinner in a Chinese restaurant in Florence.
Florence in July was very different: vibrant, sunny (tolerably hot), and yet it had the same beautiful architecture — Florence was largely untouched by World War II. Though it felt like it had been invaded by Chinese-made “authentic Italian” leather goods.
I was taken by a story of Florence and Rome fighting over Michelangelo’s body. Michelangelo was born near Florence, but spent the last 30 years of his life in Rome (he was not a fan of the ruling Medici prince). When he died in 1564, he was initially laid to rest in Rome. However, the then-ruling Medici (another one) decided that since Florence could not honor their favorite son during his life, they’d honor him posthumously. They stole Michelangelo’s body from Rome about three weeks after his death and brought it to Florence, where he lies today. This is what it means to be a great artist — cities fight over your earthly remains.
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Today I am going to share with you part two of what became a five-part summer letter to IMA clients. The letter is very long. For readability I am breaking it up into smaller chunks, which I am going to share over the next few weeks. In part one, I discussed the economy. Today I am going to discuss the Magnificent 7 and the skew they are causing in the stock market.
In the last three parts I’ll cover lessons from past technological booms and busts, EV and AI, our investments in these areas, and the impact AI is going to have on the economy.
In these client letters, I am not selling anything; they are written to IMA clients, who have already bought into what we are doing. I don’t like sanitizing my letters (rewriting them into articles), as I don’t learn anything from doing it, so I am leaving them as I wrote them.
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And one more thing. Some of you like listening in addition to reading. Well, you can have my articles read to you by a professional narrator (not me). This is my way of saying we have a podcast, appropriately titled “The Intellectual Investor.” Last year we also started a new series of episodes called “Conversations with Vitaliy,” where yours truly (in his own voice) discusses various topics on investing, life, and music. You can listen to it on https://investor.fm/podcast/ or wherever you get your favorite podcasts.
The Magnificent 7 and the Dangers of Market Hype
You can also listen to a professional narration of this article on iTunes & online.
Despite the S&P 500 showing gains in the mid-teens, the average stock on the market is either up slightly or flat for the year. Most of the gains in the index came from the Magnificent 7 stocks, which constitute 35% of the index! The equal-weighted index, where the Mag 7 have only a 1.4% weight, is up only about 4% this year (as of this writing).
The Magnificent 7 are starting to look like the Nifty Fifty stocks from the 1970s (Kodak, Polaroid, Avon, Xerox, and others) — stocks you “had to own” or you were left behind — until all your gains were taken away or you faced a decade or two of no returns. Forty years later, it’s easy to dismiss these companies as has-beens. They’ve all either gone bankrupt or become irrelevant. But back then, they were the stars of corporate America, just like the Magnificent 7 are today.
As an investor, it’s crucial to know which games you play and which ones you don’t.
Let me explain.
For every company we own, we build a financial model; make reasonable projections of revenues, margins etc. for decades into the future, estimate and then discount cash flows (bring them to today’s dollars). Finally, we aim to buy the company at a discount (margin of safety) to whatever range of fair values the model spits out. Magnificent 7 stocks require us to draw straight lines with cash flows growing at significantly elevated rates far into the future, and even then, we get values yielding either mediocre or negative returns — forget about any margin of safety.
Their valuation demands a perfect, highly prosperous vision of the future with little competition and insatiable demand for whatever they produce. Though these are truly terrific companies, which dominate their industries, and have track records of success and growth, the financial history of markets is not on their side. Their valuation reflects only optimism and nothing else. In all fairness, I am discussing these seven stocks as a monolith, and they are not. For instance, Nvidia’s valuation is a lot more demanding (it is a very expensive stock) than Google’s (which is less expensive), and so on.
The reason I am zooming in on these stocks is because they are “the market” today, or at least a huge part of it. When you hear or read about “the market” being up or down at any specific point, this is usually a reference to the S&P 500 (SPY) market-capitalization-weighted index. If you look at the equal-weighted cousin of the S&P 500, the RSP, it has underperformed SPY by 27% since January 2023.
Don’t get me wrong, the average stock in these indices is expensive. We have a hard time finding new stocks to buy, and we have been looking nonstop (most opportunities have come outside of the US). But most of the action and price appreciation that has driven “the market” has happened in those seven oh-so-magnificent stocks.
The majority of people who are buying these stocks today are not thinking about cash flows decades into the future. They’re thinking, will these companies beat estimates over the next six months? What happens to their earnings (they don’t even pay attention to cash flows) past this short time frame is irrelevant; it’s not part of that game.
We don’t play this game for several reasons. Let’s be honest — we’re not good at it. It would be like a marathon runner trying to compete in a 100-meter race. It’s endurance vs. quickness. We focus on the endurance (survival) strategy.
Also, if people are honest with themselves, most are horrible at that quick game. You’re looking for a greater fool to buy an overvalued asset. When the market runs out of greater fools, as it always does, the punishment is equally quick, and it’s severe.
A Small Hedge
We put in a small hedge (in accounts where we had option authorization) by buying puts on the S&P 500 (SPY). These instruments appreciate in price when the market declines. Think of it as minimal insurance with a 10–15% deductible that will expire on January 17, 2025. I wrote about option hedging in the past; you can read about it here.
The question comes to mind: Why not hedge the full portfolio? Answer: because that’s very expensive, despite options being relatively cheap today. There is a well-known investor I respect who had horrendous returns over the last 20 years (his fund is down 50%) because he ran a fully hedged portfolio.
This hedge is not supposed to “save” the portfolio if the market declines, but to provide a tiny buffer and cash infusion if/when “the market” significantly cracks. Our biggest hedge is our carefully constructed portfolio (of high-quality, undervalued businesses) itself.
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I’d love to hear your thoughts, so please leave your comment and feedback here. Also, if you missed my previous article “Understanding Today’s Economic Landscape”, you can view it and leave a comment here.
Below is my latest Youtube video:
Rachmaninoff | Piano Concerto №3
“Music is enough for a lifetime, but a lifetime is not enough for music.”
― Sergei Rachmaninoff
The first time I heard Sergey Rachmaninoff’s Piano Concerto №3 I was twenty-two years old. I grew up listening to his second piano concerto — it was “my concerto.” And then I watched the movie Shine with Geoffrey Rush and the third concerto became mine, too, so much mine that I’ve listened to it thousands of times (that is not an exaggeration).
This concerto is one of the most technically challenging pieces of music ever composed for piano. Rachmaninoff dedicated it to Polish pianist Joseph Hoffmann, who never performed it in public, saying it was “not for him.” Rachmaninoff was an incredibly gifted pianist, one of the best who ever lived, and thus he was the first to perform the concerto himself, in New York in 1909. One of the early performances was conducted by Gustav Mahler.
Rachmaninoff left Russia in 1917 on the eve of the Soviet revolution and immigrated to the US. For a long time he had to make a living as a pianist, giving 60 concerts a year. Though that may sound like a lot, it is nothing compared to the work ethic of Franz Liszt — another piano-music genius who was both composer and pianist — who at one point in his life gave 400 performances a year.
Rachmaninoff’s life as a composer had a lot of tension in it. He was one of the last composers of the late Romantic era and was constantly being run over by the transition to the modern classical (atonal) music era.
Here is what Rachmaninoff said about modern music:
“The new kind of music seems to create not from the heart but from the head. Its composers think rather than feel. They have not the capacity to make their works exalt — they meditate, protest, analyze, reason, calculate and brood, but they do not exalt.
“I feel like a ghost wandering in a world grown alien. I cannot cast out the old way of writing and I cannot acquire the new. I have made an intense effort to feel the musical manner of today, but it will not come to me.”
Until I read this I had not realized that I have an old (romantic) soul, too. Just like Rachmaninoff, I never graduated to embracing the modern classical music era. And we are not talking about Metallica or AC/DC here; no, but you cannot pay me enough to listen to Stravinsky’s Rite of Spring. Just to be clear, it is my defect — that music just doesn’t click with me. There are a few exceptions — Gershwin’s Rhapsody in Blue, Shostakovich’s Piano Concerto №2 and Leningrad Symphony, Khachaturian’s Spartacus ballet, and a few others.
Today I am going to share with you many performances of Rachmaninoff’s third concerto, but I’d like to discuss three. The first is by Rachmaninoff himself. Note that Rachmaninoff performs it in 30 minutes (everyone else plays it in around 44 minutes or longer). The second performance is by Vladimir Horowitz, the Russian-born Jewish American pianist who popularized this concerto in America in the 1930s. Rachmaninoff and Horowitz were close friends. They even rehearsed this concerto together, Rachmaninoff accompanying Horowitz by playing the orchestra part on the piano. The third one by Evgeniy Kissin, also a Russian-born Jewish pianist, who is only a few years older than me. This is by far my favorite performance; it’s very dear to my heart.
I really don’t want to sound like a music snob. Let’s make that even clearer. I do not qualify as one. I do not play an instrument; I can’t even read music. I cannot tell the difference between a C major and a D minor key. I would not even be able to identify the differences in various performances of Beethoven’s Emperor concerto. But maybe this what makes Rachmaninoff third mine — I listened to it so much that I internalized it, and now I have a preconceived notion (right or wrong) of how it should sound.
As I am writing I have realized an interesting dichotomy between composer and performer. The composer creates music, the performer re-creates it. This is where it gets interesting. When Rachmaninoff was performing his third concerto, he was both creator and re-creator.
As much as I love this concerto, Rachmaninoff’s re-creation of it is my least favorite — it is too fast, and it lacks drama, conflict, tension, which to me is the essence of this piece. Rachmaninoff breezes through it, and so does Horowitz. I’ve listened and relistened to every single performance on Spotify and YouTube, and Kissin’s is the one that clicks with me (though there are many other great ones).
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to bonus@soulinthegame.net.
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