SHARES in tech companies have been on a tear so far this year, rising as much as 30% globally in the first five months, leaving a torrid 2022 behind them.
While the S&P 500 index of large U.S. public companies appears to be up 9% year-to-date, the gains are entirely driven by technology and online companies. Excluding the companies in the technology and related communications sectors, which make up 37% of this benchmark, the 418 remaining companies in the S&P 500 outside of these sectors are collectively trailing -2.4%.
Typically an environment of rising borrowing costs, as we are in today, is a negative headwind for growth sectors such as technology, but what has boosted their share prices in recent months has been the excitement over artificial intelligence (AI) – the development of machines that can process, learn, adapt and make decisions quickly in large amounts of data in real time.
While AI has been in development for some time and is already being applied by some companies in areas such as supply chain logistics management, fraud detection, and digital voice assistants such as Amazon Alexa and Apple’s Siri, interest in AI and its potential has exploded since then. the launch of the ChatGPT app in November 2022.
The free-to-use AI “chatbot” tool allows users to have human-like conversations and can be used to generate content such as articles. The wave of interest was unprecedented, with ChatGPT reaching one million users in five days, breaking the records of other apps in gaining their first million users, such as Spotify (150 days) and Facebook (300 days).
The possibilities of developing such disruptive technologies are enormous, perhaps even greater than the advent of the internet, which has undoubtedly had a major impact on how we live.
The potential application of AI is in many areas of life, including improving productivity, scientific research, resource management, and even culture with the creation of art and music.
Goldman Sachs estimates that generative AI tools — a branch of AI that creates content such as articles, communications, and images — alone could generate a 7% increase in global GDP and 1.5% productivity growth over a 10-year period .
Among other applications, such as powering factories, where robots function around the clock and don’t strike, and medical discoveries, AI could be a driver of the next industrial revolution.
But it has also led to a lot of discussion about the risks, ethics and the need for regulation. Tesla founder and Twitter owner Elon Musk co-signed a letter earlier this year warning of the risks of developing “non-human minds that will ultimately outnumber, outsmart, obsolete and replace us.” And this week, more than 300 leading figures in the technology sector issued a near-apocalyptic warning AI could lead to the extinction of humanity.
Identified dangers include encouraging an exponential increase in the spread of misinformation, enabling authoritarian regimes to enforce surveillance and censorship, and the development of new weapons.
AI’s massive productivity gains will come at a price: the displacement of millions of jobs currently performed by humans. These are not only factory workers, but white collar jobs are also at risk.
Goldman Sachs estimates that two-thirds of occupations could be partially automated and that 300 million jobs worldwide could be replaced by automation. However, new roles will also emerge, as in previous periods of industrial innovation, where large companies are already starting to ramp up hiring in AI-related positions.
As investors pour money into AI-related investments, it’s wise to take to heart the lessons of the dot-com bubble of the early 21st century, the eventual burst of which led to massive destruction of capital.
While some companies survived this crash and prospered, others went under without a trace as their lack of actual profits and unstable business models came to light.
Inevitably, all kinds of big companies will start talking about how they use AI – as many did about their online presence during the dotcom bubble. More noise around corporate AI will make it harder for investors to identify the more attractive plays.
It is often said that during the Great American Gold Rush, the guys selling picks and shovels made more money than the average gold miner and this could very well be true when it comes to investing in AI.
Identifying which sharp new AI developers will prove to be long-term winners is like picking a needle in a haystack. What we do know is that the computational power essential to the development of AI will create a huge demand for microchips, which will benefit giants like NVIDIA, ASML and TSMC.
Since AI also relies on processing massive amounts of quality data, online platforms such as Alphabet, which owns Google, and Meta, which owns Facebook, will benefit.
Investors have already understood this, with NVIDIA’s stock up 178% since the start of the year and its market value briefly reaching $1 trillion, placing it among the top five companies in the world. The incredible surge included a one-day 24% increase, following a recent earnings call in which the company outlined massive demand for its chips from companies developing their AI capabilities, resetting investor expectations.
In periods of market euphoria like this, it’s important not to overlook caution, as rising valuations of alleged AI beneficiaries are pricing in a huge amount of optimism about future earnings growth.
The 68 AI-linked companies in the Robo Global Artificial Intelligence Index are valued in aggregate at a whopping 42 times their projected earnings for the next year, much higher than the FTSE 100 at 10.5 times.
But when one part of the market attracts large amounts of hot money, valuation bubbles can last for some time before bursting. At the peak of the dot-com bubble, technology stocks were trading at 70 times earnings before crashing back to Earth, so at 42 times AI stocks there would be some way to go to match this.
In short, AI is a breakthrough technology that we consider an investment megatrend that should not be ignored. But excitement and enthusiasm must be tempered by understanding the risks of the more speculative games and it is vital to keep a close eye on valuations as they become disconnected from reality.
Jason Hollands is a managing director at asset manager Evelyn Partners, which operates from offices in Glasgow, Edinburgh and Aberdeen.