Why fundies are closely watching the AI market ‘froth’

Given the massive disruptive potential of artificial intelligence (AI), it’s been easy for markets to get excited but there’s more to the trend than meets the eye, according to these portfolio managers. 

The calendar year began with a seemingly AI-driven tech rally following the release of ChatGPT, developed by OpenAI, in late 2022. Since announcing the third phase of its long-term partnership with OpenAI through a multiyear, multibillion-dollar investment in January, Microsoft’s share price was up some 35 per cent year to date as of 15 August 2023.

Not far behind, Google’s parent company Alphabet invested some $461 million in start-up Anthropic and previously leaned into the potential of the technology with the acquisition of DeepMind in 2014. It has promised to infuse these developments into over 20 of its products and features, and has seen its price rise some 47 per cent year to date. 

Still, the most fascinating case of all this year would likely be Nvidia, which was briefly valued at over $1 trillion since commenting about the demand for its data centre chips in May. Market watchers were stunned to see the stock’s value triple in less than a year, thanks to the AI boom.

With all this, the Nasdaq has seen a jump of over 30 per cent in the first six months of the year in its best first half for the last four decades while the seven mega-cap tech firms accounted for almost all the gains in the S&P 500 over the same period.

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This was a welcome change from a sell-off in 2022 where expensive valuations led to the third-worst year for technology since the Global Financial Crisis in 2008 and the bursting of the dot-com bubble in 2000.

Justin Thomson, head of international equity and CIO at T. Rowe Price, feels potential now lies in the mega-cap companies, including the likes of Apple, Microsoft, Nvidia, Amazon, Tesla, Meta and Alphabet, which are “well positioned” to benefit from the trend. 

“There’s an AI arms race underway and I think that means the strong will get stronger,” he said in a market update.

Picking winners

Looking at these trends, managers continue to prep their portfolios for AI exposures to make the most of the tech rally while acknowledging that broad stroke exposures to all types of technology is not the solution. 

“I am normally very sceptical about the latest transformative tech breakthrough, and watched the exuberance rise and fall around Web 3, the metaverse and crypto architecture last year,” said Trent Masters, global portfolio manager at Alphinity Investment Management. 

“But with the use cases and subsequent earnings potential that I can see being built off the back of AI, I do think this technology shift, and the value that it can create, is real.”

While emphasising the need to be selective to wade through the ‘froth’, as is the case with any new disruption or trend, he said he sees multiple opportunities within AI investment.

Outside of the usual mega-cap suspects, he expects semiconductor designers like Nvidia and to a lesser extent AMD and Broadcom could benefit, along with foundry businesses like TSMC and Samsung; network businesses such as Arista and Juniper; and semiconductor equipment players such as ASML, Applied Materials and Lam Research. 

The really exciting opportunities, however, will lie in the emergence of businesses that apply AI to a deep revenue pool and own that particular vertical, likely to be seen on a medium- to long-term horizon, he said. 

“Whether that be in healthcare, finance or customer service, there is the potential for an AI leader to emerge that could be the next big tech name in three to five years. That is what I’m also keeping my eyes out for,” Masters told Money Management.

Speaking at the Pinnacle Summit Series 2023, Anthony Doyle, Firetrail’s head of investment strategy  for the Firetrail S3 Global Opportunities Fund, said AI will have huge productivity gains for the economy and a massive impact on various sectors and companies.

With this, Doyle stated the fund was “really comfortable” with its AI exposure. 

“We own TSMC, Alphabet, Microsoft, Micron Technology … A company in our portfolio that has benefited is Schneider which develops the components required for the high-voltage data centres. Certainly, the hype is real,” he said.

“Whether the heroic assumptions for earnings come through the next couple of quarters is debatable, but longer term, the markets have been quick to price in the gains and I think that’s probably right.”

Chris Iggo, chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core, believes there is a long way to go in terms of introducing and exploiting machine learning and AI in multiple sectors across the global economy. 

“It is hard not to be bullish on technology over the long term as a result. Indeed, I believe AI – together with the energy transition and huge strides being made in biotechnology – provides lots for growth-focused equity investors to be excited about.”

Waiting and watching

As investors continue to observe markets carefully, managers suggest taking a long-term view for these returns and some are sceptical about its prospects.

In a recent Natixis Investment Managers survey of over 30 fund strategists, including economists, analysts and portfolio managers, there was an even 50 per cent split between those who believe AI will drive long-term growth and those who see AI as the next bubble. 

Also speaking at the Pinnacle Summit Series 2023, Dr David Allen, head of long/short strategies and portfolio manager of the Plato Global Alpha Fund, said the market had got very excited with the AI trend and perhaps even run a bit ahead of itself.

“We owned Nvidia going into the blockbuster results and ASML is one of the bigger holdings, so we’re a big believer in this space,” Allen said.

“In terms of how far the market has run on the back of that, I think that it is overrun, particularly with inflationary concerns. Most of the real benefits to cash flow revenue earnings, they’re not going to occur in the next six months. They’re going to occur in the next two years and next decade or so.”

Alphinity’s Masters agrees that a market rally that is this narrow doesn’t tend to last.

“I think there is a real danger in some of these companies pulling an AI-related valuation bump into their share prices without a more clearly defined monetisation roadmap as, if there is disappointment on the earnings front, the share price reaction will be severe,” he observed.

“We have seen the front edge of this through reporting season where companies such as Datadog and Palantir have had quite solid falls after earnings disappointments, while some of the air has come out of other companies such as MongoDB, Snowflake and Salesforce. 

“So, while I do think that exposure to AI is required, you need to be able to have a line of sight to the earnings potential and to be disciplined in terms of what you pay for these companies, like in any investment opportunity, and also have this exposure alongside a more diversified set of investment opportunities within an investment portfolio.

“But a market rally this narrow doesn’t tend to last, so I’d expect the market to become more balanced over the second half of the year as some of the initial AI-induced enthusiasm wanes and valuations across tech become more of an anchor compared to the rest of the market,” he told Money Management.