Investing for better, not worse

We try to buy attractively priced companies that are getting better. We sell companies if they’re getting worse. It's that process that we're wedded to, rather than to the companies themselves. So we make no pledges of fidelity – we’re trying to help our clients to become richer, not poorer. 

That approach may seem obvious, but millions of investors don’t follow it. The investment decisions of 'passive' investment funds – those that aim to match the returns from a specific market or index rather than beating it – make no reference to whether the companies they own are improving or deteriorating. Just one question drives what they buy and sell: how big are they?

The performance of passive funds has come to rest on returns from a handful of large tech companies

As a company’s market value rises relative to others, it comes to represent a larger share of the index – so more of the money invested in passive funds that track that index is allocated to it. The rise of the US technology giants, particularly the so-called 'Magnificent Seven' companies (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) and the AI boom have meant returns from the biggest companies have outpaced the rest of the US market in recent years. Passive funds both contributed to and benefitted from that trend.

If more people shift to passive investing – and they have been – then a cycle can build: the biggest companies get bought more heavily; their share prices rise; their market value increases; and passive funds automatically buy more of them.

So far, so good. In the past five years, the top 10 stocks in the S&P 500 index have risen by 380%, compared with 75% for the index¹. Thanks to this, a greater proportion of passive investors' money is crowding into the market's biggest stocks. The top 10 stocks in the S&P 500 have grown to represent 37.6% of the index². But here's the worry: we believe the share prices of some of these companies now look too high relative to their underlying profits. In other words, we think they are overvalued.

And that brings me to another important point about 'active' investors like us who, rather than simply copying a market index, choose which companies' shares to buy, sell or avoid. We look for companies where we believe the opportunity to make a return for our clients (the 'upside') is significantly greater than the potential downside risk. Valuations – the company’s share price relative to its underlying financial health, including its profits – are an important part of that. 

A company may be getting neither better nor worse, but if the invisible piece of elastic that connects a company’s share price to its profits stretches too far – if it is overvalued – then the risk balance tilts the wrong way. The opportunity for its share price to rise shrinks and the risk of disappointment grows.

There are risks in the Magnificent Seven

So what happens if the world decides the large US technology companies have got poorer and are overpriced? What happens when a virtuous circle goes into reverse? And is such a reversal possible?

As a result of the Magnificent Seven's investments in AI, the cash they have left over after paying the costs of running and investing in their businesses ('free cashflow') has started to shrink. They are investing billions of dollars into a race in which there may be only one or two winners³. 

Magnificent Seven - Slowing profit growth

Hedgeye as at 5 May 2026. The Magnificent Seven stocks are Alphabet, Amazon, Apple, Microsoft, Meta, NVIDIA and Tesla. "Profit growth" is defined as year-on-year net income growth.

Their advantage over the rest of the market is already narrowing. The Magnificent Seven’s profits were growing at an annual rate of more than 60% at their peak in the final quarter of 2023⁴. Those profits are still rising, but more slowly. FactSet, a global financial data company, expects profit growth among the other 493 companies in the S&P 500 to exceed 20% later this year – and to overtake the Magnificent Seven by the final quarter of 2026.⁵

In June, Alphabet said it would sell $80bn worth of new shares to fund its AI investments⁶. This came after it had borrowed almost $32bn from the bond market⁷. Alphabet and five other large technology companies – Amazon, Meta, Microsoft, Oracle and SpaceX – are expected to spend around $870bn this year on their AI investments⁸. 

What happens if these companies struggle to make enough money from their AI products and services to justify their investments? Although we don’t believe there is an ‘AI bubble’, we don’t think all of these companies will necessarily be winners. 

Because we are active investors, we try to discriminate between winners and losers. We can reduce or sell any holdings we have in any of the Magnificent Seven companies if their AI investments don't appear to be paying off in the way the market currently hopes. And we can add to them again if something positive happens to make us revisit our view. 

What happens if the world decides the large US technology companies have got poorer and are overpriced? What happens when a virtuous circle goes into reverse?

Of these companies, we have been most positive about Amazon. We believe the combination of its well-established AWS 'cloud' business – through which it rents out computing power and data storage to other companies – combined with its expertise in designing chips used in AI applications leaves it well placed to be among the winners in the AI arms race. 

Elsewhere, we were early to buy companies that act as suppliers to the AI investment boom, such as Advanced Micro Devices (semiconductors) and Seagate Technology (storage). Companies like these went through lean times after Covid but strong demand is allowing them to charge higher prices.⁹ 

We have also looked again at some software companies. In many cases, these companies' share prices fell as the market worried that their services could potentially be replaced by AI.  We now see scope for their shares to rally as the market realises AI might actually benefit them. Increasingly, we’re also looking at areas outside of AI where share prices have been under pressure for several years but that are now showing signs of recovery, such as healthcare. In other words, we’re looking for companies that are improving. We believe investing “for better, for richer” beats investing purely on size.