In an AI Arms Race, Investors Should Focus on Profit Potential
Artificial intelligence (AI) is everywhere these days. Not surprisingly, companies have tried to pair up with this fashionable concept in any way possible. But we may be seeing the beginning of a rotation out of AI stocks that could ultimately separate the players from the pretenders.
Investors must now decide if this is a momentary blip in the AI story or a rotation toward broader market participation. We believe many high-quality companies that have been left behind in the two-year technology boom could be rewarded if a more sober view of AI-driven shares takes root.
As the Pendulum Swings
There’s no denying the appeal of AI, which promises to revolutionize how companies do business by automating routine tasks that would otherwise consume valuable human resources. Through the first half of the year, it seemed that companies referencing AI on earnings calls or in conference presentations were rewarded with consistent share-price bumps. The result was a valuation halo around anything related to AI, while the rest of the market saw relative valuations wither.
But in July, the pendulum began to swing the other way. It started on July 11, when small-cap stocks staged a meaningful rally, while mega-cap technology valuations faltered. That was followed by another rotation in late July and early August when many tech companies reported earnings. These momentum swings at times involved indiscriminate selling of tangential AI names with otherwise well-diversified business models—creating buying opportunities in the process.
Today’s Profits or Tomorrow’s Promise?
In our view, there’s a distinct difference between companies benefiting from AI today and those hoping to make AI a relevant part of their future business plans. Chip companies such as NVIDIA, which manufacture the GPUs that power machine learning, clearly fall into the first bucket. Similarly, tech companies like Microsoft that are seeing incremental cloud growth driven in part by AI spending could also be near-term beneficiaries. However, many other companies fall into the second bucket—in particular, those planning for AI but not yet profiting from it. It’s these firms that the market has begun to view with a more skeptical eye.
Investors are paying especially close attention to return on AI investment (ROAI)—made all the more important by massive capital spending among technology’s reigning kings. Microsoft is expected to spend roughly $73 billion in the calendar year 2024, followed by Amazon (nearly $70 billion), Alphabet Inc. ($50 billion) and Meta Platforms (just shy of $40 billion). While not all the spending is on AI, the aggregate outlay of about $230 billion in one year is eye-popping, to be sure, and a huge change from the roughly $100 billion spent in 2020 (Display).