Investing in AI: hype and hope

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Just had a break to walk the 100 mile UK South Downs Way from Winchester to Beachy Head on the south coast. The plan was to put in 20 miles a day for the first four days and then relax. dream on!

The third day was the killer. My blistering pace resulted in . . . well, blisters. Able only to limp, I had to abandon the final stages of the trek. I will finish it one day, but at a more prudent pace.

Perhaps not surprisingly, you’ve been reflecting on how we sometimes allow our enthusiasm to blind us to the practical realities of life. In the investment world, the most recent example of this is artificial intelligence (AI).

Artificial intelligence has become so popular that any CEO who mentions it in their plans is likely to see a decent rise in stock price. It’s even hotter than mentioning the metaverse a couple of years ago, but maybe it’s better to forget about it.

Is the investment hype around AI pure hype and hope? It’s exciting, but it’s not new to many investors. Specialized funds and ETFs in this space date back several years, well before the launch of ChatGPT triggered much of the recent hype. Those of us interested in big data have understood for several years that the technology would progress and require processing power. We recognize its potential and some of its limitations.

valuation discipline

Even if we agree that AI is a great thing and a lot of people are going to make a lot of it, investors still have to try to figure out which companies could benefit. Perhaps most importantly, is its stock worth buying? There is a difference.

It’s essential to justify the price you pay for a stock in terms of the cash that will eventually back it. This requires assumptions about costs, growth, taxes and, with technology stocks, the dilution of shares issued to “pay off” management and staff. Analysts who value technology stocks often do so based on sales revenue. All of these assumptions become strained, exciting as the growth story is, when a stock trades at roughly five times sales.

During the tech bubble of 2000, Sun Microsystems saw its shares rise to $64 before falling to $10. Co-founder Scott McNealy later challenged the valuation discipline of investors who had bought or held his shares at the peak.

“At 10 times earnings, to give you a 10-year payback, I have to pay you 100 percent of earnings for 10 consecutive years in dividends,” he said. “That assumes I have zero cost of goods sold, which is very difficult for a computer company. That’s zero expenses, which is really tough for a company with 39,000 employees. . . assume I don’t pay taxes. . .[and]it assumes that with zero R&D for the next 10 years I can maintain the current rate of revenue run. . . What were you thinking?”

Investors should beware of “What were you thinking?” actions in the AI ​​universe. Some might argue that the chip designer nvidia has reached that state. Processing power seems to be the bottleneck in the rise of AI, so Nvidia seems well positioned to benefit. But shares have tripled since last September in AI history.

Today, Nvidia is valued at $773 billion and has sales of about $27 billion. In other words, the company is priced at almost 29 times sales. Those sales could grow rapidly with AI, but even if the company maintains its current margins forever, by my calculations, it would need to increase sales about eight times to justify the current share price.

Are there alternatives? Nvidia is now “worth” almost twice the value of the world’s largest chipmaker. TSMC, which we own, builds Nvidia’s chips (among others) and has $2.3 trillion in sales, so it’s valued at a price/sales ratio of six.

And then there’s Intel. Those with good memories may remember the early 1990s, when processing power was the limiting factor in what your personal computer could do. So important was its processor that the PCs were labeled “Intel inside.” The company’s shares peaked at just under $74 in 2000; today they are worth a little less than $30.

Intel makes central processing units (CPUs), not the graphics processing units sold by Nvidia, which were originally designed for gamers and which, for speed, break tasks into many smaller parallel tasks. CPUs tend to do things in sequence. Speed ​​is sometimes mission critical (for example, if you want to mine a bitcoin, there is no prize for coming in second). But for many tasks, the speed and cost of processing will pay off. Intel shares trade at 2.2 times sales. I have bought a few at that price.

We should consider Google and Microsoft as well. Both have been working on their own chip designs for a few years. Google is expected to use its own chips (called tensor processing units, TPUs) in its cloud servers starting in 2025. Microsoft Rapid Assured Microelectronics Processor The US Department of Defense is already using the company’s Azure cloud design.

Technology will advance. How long until next-generation graphene chips hit the market and offer 10 times the speed of current chips?

These two companies (we have both) have another advantage. In essence, what AI does is process data very quickly. But you need that data, which is good for people who have a lot of it. Google, for example, has all the searches that we have written in it. Microsoft has its Bing search engine, and it’s busy collecting data on its own.

We have another company that could benefit: Accenture, the world’s largest IT consultancy. Its customers are primarily companies whose internal IT will need support to address the opportunities and challenges of AI.

Will AI transform the fortunes of any of these businesses? It should provide a useful tailwind.

Invest with caution

But this is a complex area. Many different views will be offered by people who are much more capable with a screwdriver and a soldering kit than I am in the coming months. Technology will advance. How long until next-generation graphene chips hit the market and offer 10 times the speed of current chips? There will be several ways to touch the subject. And it will be just as important to consider which of your actions might be undermined by the new technology: AI can destroy as many businesses as it creates.

It’s good to have AI beneficiaries in your portfolio. But be careful with valuations: if you’re relying on growth for return, set realistic expectations. Hope is good, but it will not win everything.

Last week reminded me of that. My sore feet healed in a couple of days; it can take much longer to recoup investment losses.

Simon Edelsten is co-manager of Mid Wynd International Investment Trust and Artemis Global Select Fund