VOO - MGK: Vanguard's Mega-Cap Growth ETF Is 'AI Heavy'

2023-06-13 12:17:51 ET

Summary

• Driven by strong global brands with leading market positions, the Vanguard Mega Cap Growth ETF (MGK) has doubled the returns of the S&P 500 since August.
• It's no coincidence that all these stocks are excellently positioned relative to the oncoming AI revolution.
• Almost all of these leading companies have strong balance sheets, large cash positions, and strong free cash flow generation profiles - enabling them to invest in AI.
• The MGK ETF is an excellent long-term core holding for investors - especially those with too little exposure to top companies like Apple and Microsoft.

The Vanguard Mega-Cap Growth ETF ( MGK ) has more than doubled the returns of the S&P 500 since my previous Seeking Alpha buy article on the fund last August (see MGK: Cream of the Crop ). While many analysts and investors complain and rattle on about the market being led by a handful of the biggest companies, the simple fact is this: They have been leading the market for well over a decade, both pre- and post-pandemic. Given that these companies have excellent global brands and are on the leading edge of technology and innovation - especially in AI - I see no reason for this dynamic to change over the next decade. In fact, one could argue that AI will only accelerate these companies' leadership positions. That being the case, I continue to rate the MGK ETF as a buy and for consideration as a long-term core holding for those investors who may have too little exposure to these great companies.

Indeed, as the graphic below shows, over the past decade, the MGK ETF has significantly outperformed the broad market averages as represented by the Vanguard S&P 500 ETF ( VOO ) and the SPDR DJIA ETF ( DIA ). That said, and despite the 2022 bear market in the technology sector, note the Invesco Nasdaq-100 Trust ( QQQ ) significantly outperformed MGK over that same time frame (which is why I also advise investors to own the triple-Qs):

Investment Thesis

The investment thesis in the Vanguard Mega-Cap Growth ETF is relatively simple and straightforward. These stocks (see below) all have:

• Strong global brands.
• Strong or leading market positions.
• Strong track records of innovation.
• Strong positions in AI.
• Strong balance sheets with large cash positions.
• Strong free cash flow generation.

For investors with a long-term perspective and who don't get caught up in short-term market gyrations, a slew of non-stop economic data, and valuation levels that can be quite volatile, the MGK ETF can be an excellent addition to portfolios that don't have adequate exposure to these great companies. Let's take a look at some of them.

Top 10 Holdings

The top 10 holdings in the MGK ETF are shown below and were taken directly from Vanguard's MGK webpage, where investors can find more detailed information on the fund.

As you can see, the MGK ETF is significantly overweight in its top two holdings: Apple ( AAPL ) and Microsoft ( MSFT ), which in aggregate have a 30.7% weight as compared to the two companies' 13.7% weight in the S&P 500. That being the case, this ETF is likely not a good choice for those investors that already have full positions in Apple and Microsoft and are looking to diversify their portfolios. However, for those investors that don't have full positions in these two companies, the MGK ETF is an excellent way to gain diversified exposure to them.

Apple, the #1 holding with a 16.2% weight, recently hit an all-time high after unveiling its new $3500 AR/VR Vision Pro headset . While I have my doubts about the near-term success of this product line, it's clear that Apple is looking long-term and wants to get the development community on board now. Meantime, Apple's base businesses (iPhone, Mac, iPad, Wearables, and Services) all continue to look strong with the iPhone upgrade cycle always seeming to be a positive catalyst going forward.

The #2 holding is Microsoft with a 14.5% weight. Microsoft continues to face strong headwinds with respect to getting its Activision Blizzard ( ATVI ) acquisition consummated, but the company continues to ride high on the back of its integration of ChatGPT and the company's position in AI.

If we count both classes of Google ( GOOG )( GOOGL ), it's the #3 holding with a 7.5% weight. Google was recently hit with an $8.6 billion fine by EU regulators due to alleged anti-competitive practices in its ad tech business model. On the other hand, GOOG has a very strong position in AI and with access to a wealth of aggregated consumer data, obviously will be able to build large language models (LLMs) for evaluation by targeted AI/ML algorithms in order to generate positive business outcomes.

Amazon ( AMZN ) is the #4 holding with a 5.8% weight. Amazon has rather quietly been on a tear YTD (+47.5%) and, like Google, has a plethora of consumer data at its fingertips to go along with its leading cloud computing segment - AWS. That being the case, Amazon can be expected to be an "AI winner" as well. As Goldman Sachs analyst Jim Covello put it :

... the barriers to entry are massive in terms of IP, capital, and established industry relationships ... the investment that companies will need to make to be successful in AI is enormous and there are only a handful of companies that can afford that investment. I think it's reasonably similar to the cloud where Alphabet, Microsoft, and Amazon have become the dominant players because they have the capital in what is also a capital-intensive game.

I would add Apple and Nvidia ( NVDA ) - the #5 holding in the MGK ETF - to Covello's list, and note that the MGK ETF is overweight all of these leading AI companies.

Meantime, note the strong cash positions of these companies as well as their continued strong free cash flow generation profiles. For example, as of their latest quarterly reports:

• Apple: $55.9 billion .
• Microsoft: $104.4 billion .
• Google: $115.1 billion .

And, as pointed out in my recent Seeking Alpha article (an "Editor's Pick"), Google continues to be my favorite mega-cap technology company due to its strong free cash flow generation compared to its relatively low valuation level ( forward P/E = 23.3x ). See Q4 Surprise: Google Generates $3.8 Billion More Free-Cash-Flow Than Exxon .

Valuation Metrics

As one would expect from a growth-oriented ETF, MGK is relatively richly valued as compared to the S&P500 as represented by the VOO ETF (metrics in red added by the author):

As can be seen in the graphic, the MGK ETF trades at roughly a 50% valuation premium as compared to the S&P 500's P/E ratio, and more than a 2x premium from a price-to-book value perspective. In return, investors get significantly higher EPS growth as well as a more than 50% increase in ROE.

Performance

The MGK ETF has a relatively low expense ratio (0.07%) that is especially notable given its excellent long-term performance track record:

That compares to the S&P 500 VOO ETF's average annual 10-year return of 11.94% .

Risks

The risks of buying the MGK ETF here is that, obviously, these leading stocks and the ETF itself have busted out of the gate this year and roared higher. However, investors should consider that almost all of these stocks were mauled by the 2022 bear market last year.

As shown above, these stocks are arguably richly valued. However, given their leading positions in AI, one could also argue that these valuations are rationale given a long-term outlook and these companies' positions in the global market.

Much of the rally this year has been based on expectations that the Federal Reserve is either done with raising interest rates, or close to being done. That said, inflation is still a considerable risk. If inflation does not slow, the Fed will likely have to raise interest rates further, which will increase the foreign exchange headwinds that all these (global) companies will face and which would negatively impact earnings and FCF.

Summary and Conclusion

I continue to be bullish on the MGK ETF given its overweighting in the planet's best-of-the-best companies and their advantaged positions with respect to the markets they are currently in, and their exposure to - and leading positions in - the coming AI revolution.

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