Artificial Intelligence: Hype Versus Reality

By Kent L. Johnson | Sit Investment Associates

Equity markets have rebounded, mainly on the heels of the exceptional performance of the technology sector, as the potential impact of artificial intelligence captured investors’ attention. While we must be keenly aware of the potential for a “hype” cycle as expectations surpass reality, we believe that artificial intelligence technology advancements will transform the overall economy and the financial markets.

Artificial intelligence (AI) is a catch-all term for systems that imitate human intelligence, making them capable of learning, reasoning, and decision-making. The rapid advancement of generative AI, which uses algorithms to create content (e.g., audio, images, videos, etc.), has raised AI’s public profile and, undoubtedly, accelerated corporate adoption. Advances in AI have progressed steadily for many years.? However, ChatGPT’s launch in November 2022 marked a significant turning point regarding user adoption and investors’ appreciation for how transformative AI will likely be.

Notably, technology adoption cycles are getting shorter and shorter; it took ChatGPT just five days to reach one million users, and it had one billion visits in just three months. According to BofA research, this is three times the adoption rate of TikTok and ten times as fast as Instagram. In this regard, the fear of missing out now prevailing in the equity markets is also occurring in the corporate community, potentially accelerating the pace of AI investment.

Despite AI’s immense potential, the ultimate economic impact stemming from its adoption is highly uncertain. Nonetheless, several studies, including those by PWC, Accenture, and McKinsey, point to a sizeable economic boost due to productivity gains, cost savings (including labor substitution), and increased innovation. This AI-led growth should have a direct and outsized impact on corporate earnings. A recent Barclays report noted the past four tech cycles (e.g., PCs, internet, mobile, cloud) coincided with robust productivity gains for companies within the S&P 500 Index.? Significant gains from AI may be some years away. Still, it could provide a much- needed boost to corporate earnings as debt and demographic headwinds intensify, particularly in the U.S., Europe, China, and Japan.

Aside from the technology sector, we anticipate AI will impact virtually every major segment of the economy, albeit to varying degrees. The sectors that may see the most considerable impact are financial services, retail/ consumer, healthcare, and manufacturing. Although direct investment opportunities are limited, AI will also profoundly impact the legal and education sectors.

Of course, the promise of AI is not without its pitfalls. First, numerous studies highlight the potential for job losses as firms deploy AI, which will have considerable economic and societal repercussions. However, recent history shows that periods of significant technological change led to productivity gains without a surge in unemployment. Second, since AI is resource-intensive, large corporations have an inherent advantage, given their ability to invest and deploy AI at scale. This “leg- up” will only amplify already-existing concerns that big firms are too powerful and squeezing out competitors to gain market share.

Unsurprisingly, calls for AI oversight have emerged as thought leaders and policymakers consider the risks. However, we are skeptical that meaningful regulation is realistic as AI continues to evolve rapidly across the globe.? The technology’s increasingly broad reach will make it difficult to determine what and how to regulate and who has ultimate supervision. Outside of targeted oversight in areas such as consumer privacy, we think the government’s primary role will be to mitigate the potentially disruptive impact of AI’s adoption on labor markets.? In addition, legal battles over copyright and intellectual property issues are inevitable as AI-created content proliferates.

Regarding investable themes within AI, we continue to see enticing opportunities in select hardware, software, and services. For instance, the accelerating build-out of AI infrastructure will require the most sophisticated semiconductors (graphics and microprocessors). Also, a reacceleration in data center capacity will benefit the suppliers of servers and associated components.? Moreover, software companies that most effectively embed AI into their product portfolios stand to gain market share. Cybersecurity providers will likely see continued growth as cyber threats become more sophisticated as AI tools become more available to bad actors.

While hardly a contrarian view, the large technology companies appear remarkably well positioned in AI as their financial strength can fund and scale the daunting capital requirements for AI development, including hardware, software, energy costs, and engineering talent. “Training” an AI model is complex and expensive, but these firms have the resources, massive installed customer bases, and extensive datasets that are unique and critical for development.

In the near term, we expect tech-related “enablers” to be the greatest beneficiaries of AI adoption, but many early adopters will realize benefits in the intermediate to longer term. We are particularly optimistic about its impact within healthcare, as the industry is inherently data-intensive, making it ideal for AI applications. The biopharma drug development process is a promising area for AI, where firms usually distill down thousands of pre-clinical drug targets to a few good candidates for human testing. While the cost savings of leveraging AI in drug development could be substantial, improving the probability of success in early-stage development could be a more significant value driver for the sector.

Also, many diagnostic firms use machine learning and proprietary algorithms to produce AI-based cancer risk assessments driven by ultrasound imaging.? These technologies have dramatically cut ultrasound image interpretation time in some applications, increasing clinician productivity and improving disease detection.

While we are highly confident in AI’s transformative potential in the intermediate to longer term, we do not dispute that much has been priced into the valuations of the best-positioned firms nearer term. Accordingly, we believe adding to positions during bouts of market volatility is a prudent near-term strategy.

About the Columnist

Kent Johnson is a senior vice president of research and investment management with Sit Investment Associates and shares management responsibilities for several of the firm’s three dividend growth portfolios, the small and mid cap growth portfolios in the firm’s custom separately-managed accounts, private investment funds and mutual funds. He also shares management responsibilities for the Sit ESG (environmental, social, and governance) Growth Mutual Fund. Kent provides fundamental research on companies in the capital goods, financial, transportation and education sectors. He leads the firm’s equity quantitative research team.

Prior to joining Sit Investment Associates’ equity research staff in 1993, Kent worked in a number of positions within the firm, including client administration and the systems department.

Kent earned an M.B.A. degree from the Carlson School of Management at the University of Minnesota in 1995. He earned a B.S. degree in finance from the University of Minnesota in 1989. Kent is a CFA charter holder.

Sit Investment Associates is an Associate Member of TEXPERS.

Disclaimers

This analysis contains the collective opinions of our analysts and portfolio managers and is provided for informational purposes only. While the information is accurate at the time of writing, such information is subject to change at any time without notice, and therefore, so may the investment decisions of Sit Investment Associates.