As of this writing, the S&P 500 has returned more than 15% year to date. Not only that, but it’s surged more than 20% from its lows of October 2022, which technically signaled a new bull market.
It would appear, especially in the eyes (and portfolios) of retail investors, that stocks are back, well on their way to generating the returns demanded by investors.
There are actually two very different stock markets this year. Let’s call the mega-cap tech companies that drove the early stages of this rally the “S&P 7.” Members of this elite squad include the seven largest1 companies in the S&P 500 index by market cap: Apple (APPL), Microsoft (MSFT), Nvidia (NVDA), Alphabet (GOOG), Amazon (AMZN), Meta Platforms (META) and Tesla (TSLA). This group comprises nearly 28% of the total S&P 500 index weight. On average, the S&P 7 have gained nearly 92% this year. Nvidia is the notable leader, with its shares surging nearly 200%, making the 40% gain of the group’s laggard, Alphabet, seem downright paltry.
Let’s call the second market the “S&P 493.” This group includes all the remaining stocks in the S&P 500, comprising 99% of the names but only 72% of the weight. This group of worker-bee stocks is not having such a great year, gaining on average only 2%. Casting further shade, only 22 stocks have produced returns that exceed the weakest of the S&P 7, and none have approached the surge in Nvidia or Meta Platform shares (cruise operator Carnival Corp. (CCL) is the best-performing S&P constituent outside the S&P 7 and it’s returned an impressive 100% to date, about half that of Nvidia).
The dour mood can be felt broadly, as small-cap stocks are also having a weak year, gaining only 6.6%.
So, with two very different stock markets this year, what should an investor do?
For those already owning one of the S&P 7, it seems like the right thing is to let the profits ride. The returns have been so stunning, and the artificial intelligence (AI) narrative is so compelling that it is easy to believe that these stocks will be “winners for years.” For those not owning the elites, it is natural to feel “left out” and to want to buy these stocks aggressively to participate in their seemingly assured future bounty. It is tempting to “buy the past returns” – that is, buy these stocks because their returns have been so strong in the past.
But, the past has passed. What about the shares’ prospects? New AI innovations in what is an old technology will almost certainly drive powerful changes over the next 20 years. But, like all tech innovations, the currently perceived winners usually are not the actual winners, even if their shares are priced that way. Nvidia shares trade at 41x estimated 2025 earnings, based on a near-doubling of earnings by then, only two years away. Estimates for Meta Platforms, Amazon and others similarly assume that earnings will double (at least) and reach record highs by 2025. But, while possible, any hiccup in this optimistic outlook would likely send the shares sharply lower.
An alternative would be to buy shares of the worker-bee technology companies. Many of these have highly relevant offerings and highly resilient although slower-growth revenues. As use of advanced AI becomes more widespread, customers will need their products and services. Some have durable balance sheets and capable management. And, a few also have shares that trade at low valuations, occasionally supplemented by attractive dividend yields.
One such company is Hewlett Packard Enterprise Company (HPE). This company was split off from the original Hewlett-Packard in 2015 as part of a multi-year shareholder value initiative. HP Enterprise focuses on gear and related software and services that help enterprises capture, store, move and use data.
Investors have ignored the company’s shares, which are essentially unchanged since the 2015 split-up. But, since the split, H-P has been busy refocusing and improving its business. Its efforts to upgrade to higher-margin and faster-growth markets, including its emerging GreenLake technology that helps companies migrate to the cloud, are boosting its already-respectable profits. Supporting its margins is a disciplined expense mentality. H-P has acquired several attractive capabilities, including those of supercomputer maker Cray in 2019, while also divesting several major non-core operations. The company recently announced that it is divesting its 49% stake in the H3C China joint venture due to geopolitical and other reasons. The exit’s valuation is attractive at 15x earnings, especially when H-P’s shares trade at less than half that multiple. And, the company could receive at least $3 billion in net proceeds, enough to repurchase 16% of its share count.
Much of what makes the shares of HP Enterprise attractive is the lack of investor interest – the shares have gained 8% this year and trade at an overly discounted valuation of 3.5x EV/EBITDA and 8x per-share earnings. Its likely $2 billion in free cash flow this year produces a free cash flow yield of 11%. HP Enterprise will likely return more than half of this to shareholders through dividends and share buybacks. Investors receive a sustainable dividend that currently yields nearly 2.8%.
So, when tempted by the alluring 92% gains in the biggest S&P stocks, consider adding some S&P 493 stocks instead. The shares may be less thrilling but could prove to be more financially rewarding.
1. Based on the official S&P 500 Index weight as provided by S&P Dow Jones Indices LLC and adjusted for a minor change in market cap based on Cabot research.
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