The Magnificent 7 Underperform: Apollo Global Management Analysis

The Magnificent 7 Underperform: Apollo Global Management Analysis

The Magnificent 7 (Mag 7) are beginning to underperform the broader market as investors shift their focus toward quality and free cash flow. This shift is driven by astronomical capital expenditures (Capex) on artificial intelligence, which are compressing margins and reducing the free cash flow of hyperscalers.

Market Rotation Toward Quality and Free Cash Flow

Investors are rotating away from the Mag 7 and toward the S&P 493 (the S&P 500 excluding the top seven companies). This rotation is the result of earnings growth converging between the Mag 7 and the S&P 493, as well as a decline in the P/E premium that the Mag 7 has enjoyed for over a decade.

Convergence of Earnings Growth

Earnings growth for the Mag 7 and the S&P 493 has converged, reducing the incentive for investors to maintain concentrated positions in the same few companies. As the growth gap narrows, the market is increasingly valuing companies based on their actual free cash flow rather than future AI-driven growth projections.

P/E Premium Compression

The Mag 7's forward P/E ratio relative to the S&P 493 has reached its lowest level in more than ten years. This suggests that the market is no longer willing to pay a premium for these companies' growth potential, questioning the valuation premiums based on AI hype.

The AI Capex Burden

Big Tech's investment in AI infrastructure is becoming a capital-intensive burden. Hyperscalers—including Amazon, Google, Microsoft, Meta, and Oracle—are spending heavily on data centers and the hardware required to run LLMs.

Impact on Free Cash Flow

Free cash flow for hyperscalers is trending downward. This is caused by the massive increase in capital expenditure as a share of operating cash flow. The cost of providing AI-integrated services (such as AI summaries in search or AI features in Docs and Meet) is more expensive to provide than traditional services, and these costs have not yet been fully passed to consumers.

Data Center Expansion

The scale of the AI buildout is projected to be projected to be massive. In the US, the number of data centers is increasing significantly, with approximately 60% more data centers planned or under construction. This expansion is further accelerating the capital intensity of these businesses.

AI-Linked Issuance and Credit Markets

AI-linked issuance is redefining credit markets and venture capital. AI-linked issuance is now a significant portion of net issuance across different channels:

  • VC: 87% of YTD net issuance is AI-linked.
  • IG (Investment Grade): 49% of AI-linked.
  • HY (High Yield): 38% of AI-linked.

This indicates that while the public markets are becoming more cautious about the Mag 7, the credit and VC markets continue to be heavily exposed to AI growth.

Community Insights and Counterpoints

Discussion among technical and financial analysts suggests several key concerns regarding the AI investment cycle:

"The invisible hand of the market is slapping the Mag-7 for capex... Investors are waking up to say: hey, you are spending all your profits on data-centers, where is the return for me?"

"The only place where they stand to make money is selling AI compute to enterprises. But with the current supply-chain challenges, the margins there are probably getting thinner."

Some analysts argue that the market's reaction is based on a small window of data, and that some Mag 7 companies, like Meta, could potentially reduce their AI spend tomorrow and restore their free cash flow immediately. Others point to a historical trend where recent winners often underperform over the long term, citing a search for diversification in concentrated positions.

Investment Implications

The overall market concentration is extreme, with the ten biggest companies in the S&P 500 making up more than 40% of the index. This high concentration makes the broader market highly sensitive to the performance of the latest AI-enablers. This combined with a cyclically adjusted P/E ratio near all-time highs, suggests a potential for near-term correction.

Sources