One of the dominant trends that have contributed to the strong equity market performance over recent months has been growing enthusiasm for the potential that Artificial Intelligence (AI) can bring, and how companies can take advantage of the rapidly evolving technology.
What is AI?
AI is technology that enables computer systems to simulate human intelligence, with the aim of solving problems that would otherwise require human intervention. AI algorithms aim to model decisions that humans would take, by undertaking research and evaluation, and can learn from outcomes, so that the results improve over time.
Although the concept of AI can be traced back to the 1950s, significant advancement in AI capability has been seen very recently. Rapid acceleration in the efficiency of so-called Generative AI, which can produce anything from speech recognition to images and text, has seen applications such as ChatGPT being used by over 100 million users every week1. Unlike traditional AI systems, which are typically used for data classification and prediction, Generative AI models learn from large datasets, and have the ability to learn and then create new content, from realistic images to speech and writing.
The investment case for AI
Businesses that adopt AI are discovering ways to harness the new technology to streamline operations, introduce greater efficiency and in turn boost profitability. For example, in healthcare, AI can help speed up drug research and provide more accurate diagnosis. Another common example is the use of chatbots and automated customer services, which can learn from responses to become more efficient.
Investors often look for developments that can disrupt the status quo and lead to new opportunities, and it is increasingly apparent that AI will continue to be highly disruptive to existing ways of working. The breadth of application of the new technology is impressive and over coming years we suspect AI technology will find greater use in a diverse range of businesses, from finance to vehicle manufacture.
Enabling AI
Whilst many companies can see efficiencies from the use of AI, businesses that provide the infrastructure to enable AI usage have been amongst the biggest gainers over the last few months. The company that may have been able to monetise the boom in generative AI more than any other is Nvidia. As the need for processing power increases, the graphics processing units developed by Nvidia are in high demand, which has helped propel the market capitalisation of Nvidia to $3.3tn, overtaking Microsoft to become the largest quoted company in the World2. Microchip manufacturers, such as Taiwan Semiconductor, have also benefitted from the increased demand for AI solutions.
Other mega-cap tech companies have benefitted from the advancement of AI technology. Google and Microsoft have integrated AI technology into search assistants and the use of cloud computing in AI applications have boosted revenue received from cloud based servers. Recently, Apple have announced the integration of OpenAI into their Apple Intelligence system which will be available on Apple devices.
Universal adoption?
If you consider the very wide range of applications that could potentially benefit from AI technology, it is increasingly clear that most businesses will look to some form of AI integration within their systems over coming years. Customer facing functions, such as website chatbots and automated phone call handling, are becoming increasingly common, and as technology evolves, may lead to business efficiencies across most industries. For example, manufacturing businesses may harness AI technology to streamline inventory management, and help decision making. Similarly, Insurance and Finance businesses are increasingly turning to AI to help detect fraud. Those companies who have adopted AI at an early stage may gain a competitive advantage, which is likely to lessen over time as more and more businesses harness the evolving technology.
An overheated market?
Investors with long memories will recall the end of the last century as being a time when market interest in technology companies reached fever pitch. Known as the “Dot Com bubble”, the value of many technology stocks during 1999 and into early 2000 was driven to totally unrealistic levels based on the premise that they would be able to capitalise on the boom in web based applications. Whilst a select few companies justified their lofty valuations, many did not, and as investor risk appetite waned, sharp falls in value were seen across much of the sector.
Despite the strong returns achieved by a number of stocks involved in AI over recent months, it is possible to draw a distinction between some of the pure speculation that was apparent in 1999 and 2000 when the tech bubble burst, and the returns that have been fuelled by the growth in AI. Firstly, positive earnings reports from tech giants such as Nvidia and Microsoft continue to offer some support at current valuation levels. Simply put, if quarterly earnings continue to beat estimates convincingly, valuations become less demanding; however, expect stock valuations to be punished if future earnings fail to deliver.
The second clear distinction between the current tech rally and 1999 is the diversified nature of businesses that are benefitting from the growth in AI. Whilst it is quite easy to identify the companies at the forefront of AI technology, it is likely that a wide range of companies across different sectors will be able to achieve efficiencies and cost savings through AI use.
Finally, mega-tech giants such as Apple and Alphabet are highly cash generative and profitable. This is in contrast to many companies that were swept up in the dot com bubble, who were many years away from profitability and typically carried high levels of debt.
The conclusion we draw is that AI stocks are certainly not cheap on a historic valuation basis. Continued earnings growth may well support valuations; however, any signs that earnings disappoint when compared to market expectations will leave valuations exposed at current levels.
Why it is important to diversify
Market attention has been focused on the AI-fuelled rally in tech names that has driven global equities markets forward over recent months; however, formulating an investment strategy that focuses on a single trend introduces additional investment risk. Building an investment portfolio that encompasses new trends such as AI, together with other, more traditional, industries, can help reduce volatility. Speak to one of our experienced advisers if you would like to discuss your exposure to the AI trend, or to review an existing portfolio.
Sources:
1 OpenAI.
2 Companiesmarketcap.com.
