Rare Air

On January 4th this year, I circulated a letter to investment clients providing a basic overview of generative AI and large language models (LLMs) like ChatGPT, as well as briefly discussing artificial intelligence-related investment opportunities (see: ChatGPT and the AI Opportunity ). While I mentioned Microsoft and made the case for not giving up on Alphabet (which the market momentarily believed was doomed) and investing in semiconductor and semicondcutor capital equipment firms, I have to say that I am astounded by the gains this year in companies that are key to the artificial intelligence ecosystem (and even some of the ones that aren't!). Anything AI related is up. A lot.

Is this a "bubble" and just "hype"? I am inclined to say no when it comes to the critical firms in the space, as AI developments seem poised to upend most industries over time - especially ones with any digital or technological component. I don't think that means everyone loses their jobs to automation (as a recent Goldman Sachs research piece suggested ), but rather that we enhance productivity and free up people for new creative, higher value endeavors. At least I hope it does't mean we lose our jobs...

So how are investors supposed to position for this? The obvious answer this year has been to own companies that either are enabling the development of AI or benefiting from it. While valuations are becoming extended, in one critical respect this isn't like the tech bubble of the late 1990s or the "disruptive innovation" bubble of 2020-2021. In those cases, you had mostly marginal companies benefiting from thematic euphoria. Right now, we have mostly real companies working on hard technological breakthroughs. And, by and large, they are the megacap firms, as the costs to develop and host LLMs, or the semiconductor chips and capital equipment critical to AI computing, are cost prohibitive for anyone but the largest companies.

AI (so far) is a unique technological advance in that it benefits incumbents. This last point is one of the reasons I've been so critical of the whole ARK "disruptive innovation" type investing approach . There are surely disruptive innovations happening - and not just in the tech sector (e.g. horizontal drilling) - but they aren't coming from the Rokus and Coinbases of the world (no offense). With the exception perhaps of the biotech industry, the most innovative work is coming from current industry leaders who have the balance sheet capacity to invest heavily in research and development (R&D) and capital expenditures (CapEx) necessary to develop next generation technologies. (And yes, I realize an upstart OpenAI kickstarted this AI public awakening, but they benefitted from Microsoft's financial support and computing infrastructure).

Below is a chart I put together this morning of the top-25 R&D spenders in the S&P 500, along with their CapEx spending and other financial/valuation data. These firms are spending tens of billions on R&D and CapEx - small firms simply don't have the ability to compete. That's not to say small firms will never be able to knock off one of the entrenched large caps in some category, but the barrier to entry is sky high. These large cap firms are in "rare air" (hence the article title...).

And the academic literature suggests that the air might be getting rarer. Most public firms wither over time. The fact that returns are scaling to the incumbents will make it all that much harder for new firms to survive, let alone break through. For every Nvidia or Meta, there are dozens of firms that didn't make it. See?this article ?on the topic of public company return distributions and contributions from the Financial Times, which cites the work of ASU professor Hendrick Bessembinder (academic paper link ).

Per Bessembinder's findings, the majority of public companies end up being losers with a small minority contributing to almost all the returns. Given the technological barriers to competition, that small minority may end up getting smaller.

Ok, so why not just buy the large cap tech stocks hand-over-fist? That's largely what's going on in markets this year and driving returns in the S&P 500, particularly over the last few months (as the below chart from Jim Bianco of Bianco Research shows):

Those who I advise and manage assets for have owned these firms for the better part of the last decade. To be fair (perhaps even self-critical), I have - with some excpetions on sell-offs - been reluctant to add to tech over the last two years and advocated picking up some unloved parts of the markets such as natural resource companies and defense firms in 2021. Fortunately, I've also advocated not selling out of tech firms. The tougher question is what do you do with new capital, or what do you do if you are sitting on large gains?

I don't have great answers. For trillion dollar firms to continue growing at double-digit rates is mind-blowing. I never would have guessed these growth rates could sustain themselves after the last decade of spectacular returns.

In 2007, Citigroup CEO's Chuck Prince infamously remarked :?"As long as the music is playing, you've got to get up and dance." Poor choice of words given the Financial Crisis unfolded shortly after... But is this a situation where that holds true? Everyone is seemingly dancing to the same AI tune in public markets. Do you have to join in or risk getting left behind?

The part of my brain that is sensitive to valuations makes me reluctant to enthusiastically say yes. I get why everyone is dancing, but I think investors need to tread cautiously. I've pulled some valuation and return data on Apple, Microsoft, Alphabet, Amazon, Meta and Nvidia dating back to Meta's IPO back in May of 2012. Over the subsequent decade all of these firms enjoyed incredible growth in their businesses and stock prices. Just look at their compound growth rates since then (by comparison, the S&P 500's price return and total return are 217% and 291%, respectively, over the same time):

Each of these companies had annualized stock price growth of at least 20% for 11 years. Look, as someone who has written about believing in UFOs , I'm the first to admit that anything is possible. But for these stocks to repeat something close to their last decade's performance, their market caps together would approach the size of current global GDP. Again, possible, but not likely. It helps prospective returns when you start small.

So let's look at a few charts showing the growth of these companies since 2012...

Market Caps:

Forward Sales Estimates:

Forward Income Estimates:

Forward Free Cash Flow Estimates:

Forward Price to Earnings Ratios:

Forward Enterprise Value to Sales Ratios:

The one stock that really sticks out today from a valuation perspective is Nvidia. I get why it's all the rave at the moment. It just exceeded consensus estimates for next quarter's sales by 50% ! Its GPUs are essential for AI and machine learning, and the appetite of the hyperscale cloud firms for them seems insatiable. That's not to say Nvidia won't face competition, as Microsoft, Amazon, Alphabet and Meta all are developing, or are rumored to be developing, competing chips that they can customize to their needs. But Nvidia has a head start on chip architecture and software. Investors have priced it as an insurmountable head start. Perhaps it is. (As an aside, one reason to remain constructive on semiconductor capital equipment firms at current valuations is that regardless of chip design, the industry will still need their advanced machinery for manufacturing.)

Nvidia's recent run and valuation reminds me of a chart on Microsoft I included in a client letter from October 2020 on factors that contribute to long-term returns. I'm not making a similar prediction whatsoever about Nvidia (or any of these tech companies), but I will just note that investors who purchased Microsoft at its peak valuation in 1999 when it traded at close to 30x its annual sales (compared to 35x for Nvidia today) and still held onto the stock 10 years later would have suffered a stock price loss of over 50% despite the company growing revenue at a compound annual rate of over 11% during the period. In fact, Microsoft didn’t eclipse its 1999 stock price until 2016 (see chart below).

Microsoft Fundamentals (1999-2009):

To repeat, I am in no way making a similar prediction for Nvidia's fate, or that of any of the other big tech companies. We are in the early innings of an AI era and there is a long runway of investments that these firms will benefit from. My only caution flag is that the higher the valuation starting point you enter a position at, the less downside for any dissapointment you give yourself.

If there's any near-term economic slowdown (see the chart below), it's fair to ask whether the customers buying chips from Nvidia, services from Microsoft or ads on Google will maintain, grow or slow their current levels of spending. That's a temporary issue in the broader arc of this AI future. But markets are punishing when companies priced for high growth decelerate.

US Leading Economic Indicators YoY (Recessions Shaded)

So what's an investor to do? In short: respect the fundamentals driving this trend, hold these stocks if you own them, but tread cautiously and be valuation sensitive if making new allocations.

I'll end with an insight I took away from a great piece by Ben Thompson in January of 2020 on his Stratechery blog from a piece he titled: The End of the Begining . Thompson made the point that after an explosion of U.S. auto companies in the first half of the 20th Century following the advent of the automobile, the industry became far more concentrated.

Thompson wrote, however, that despite the industry consolidation, the impact of cars continued to grow:

Thompson then analogized the car industry to tech and said that what drives new companies to dominance are "paradigm shifts" - much like a car was a paradigm shift from horse trasnportation. In his reckoning, the tech industry had undergone several distinct paradigm shifts at the time of his artice:

Thompson concluded that perhaps we had reached "the end of the beginning":

What Thompson couldn't have predicted three years ago is the current shift underway with AI. The difference perhaps between AI's development and former instances of paradigm shifts is that it is the incumbents themselves who are leading the way. Which begs the question is this actually a new paradigm that will benefit new companies? Perhaps, this is more of an "evolution" of existing computing capabilities than it is a "revolution." Indeed, that is what Thompson suggested in a piece from last week entitled: Google I/O and the Coming AI Battles . In discussing Microsoft founder Bill Gates' assertion thay AI represents a paradigm shift, Thompson responded:

I must admit, I'm partial to Thompson's analytical framework. AI is just getting started and the societal changes will be immense, but we're still at the "end of the beginning" from a company dominance perspective. New companies will surely build new new services on top of AI capabilities, but so far it looks like the main beneficiaries are today's leading incumbents. Fair or not, the big are going to keep on getting bigger.

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Hope all this was helpful in thinking through the current AI investment landscape. If you want to talk about any of this in more detail, feel free to reach out.

-Stuart

Disclosure:

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