Investors must be wary of ‘AI losers’ as tech valuations spike

In the face of the excitement surrounding the prospects for artificial intelligence, the market needs to do its homework on potential risks and rewards At the end of last year, plenty of experts were calling time on the decade-long technology rally. Its valuations couldn’t be sustained in an environment of higher interest rates, they said,…

The art of disruptive investing

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Cherry Reynard

In the face of the excitement surrounding the prospects for artificial intelligence, the market needs to do its homework on potential risks and rewards

At the end of last year, plenty of experts were calling time on the decade-long technology rally. Its valuations couldn’t be sustained in an environment of higher interest rates, they said, and earnings for the bellwether technology stocks, such as Alphabet, Meta and Amazon appeared under pressure.

However, the excitement around AI appears to have changed the outlook once again, with technology stocks seeing a significant bounce since the start of the year. 

The Nasdaq is up 29.9% for the year to date. That puts it ahead of the S&P 500 (13.7%) and a long way clear of the Dow Jones (1.8%). 

The stand-out winner has been Nvidia, which makes the specialist chips that power AI tools such as ChatGPT. Its share price is up 194.9% since the start of the year. 

Many investors will look to play a nascent gold rush through ‘picks and shovels’ providers as a lower cost option, but in this case, it appears many of them have had the same idea. 

Other winners include technology giants Meta (up 131.5%), and to a lesser extent Alphabet (37.3%), Microsoft (39.8%) and Amazon (50.7%). Investors are assuming that cloud services will be an integral part of gathering the big data insights needed to fuel artificial intelligence and that these companies will see demand increase. 

This has been good news for some of the growth managers beaten up by the rotation from growth to value in 2022. 

Baillie Gifford, for example, has been a significant holder of Nvidia, and this has helped offset some of the weakness seen in some of its core holdings last year. 

However, there has also been a downside as the market has started to call out potential AI ‘losers’, which may prove to be on the wrong side of the revolution.   

Alex Savvides, fund manager on the JOHCM UK Dynamic fund, says that a profit warning for US education group Chegg at the start of May has created some jitters in the market. 

He says: “AI has entered the stock market’s consciousness as a result of Chegg. The company provides homework help tools and said that its students were going onto ChatGPT, rather than using its products.” It said subscriber growth had come under pressure and suspended its full-year outlook. Its shares halved in the immediate aftermath of the warning. 

However, Savvides said this immediately prompted a sell-off in similar companies, with no immediate signs of difficulties. He added: “Pearson, for example, had had its results the previous day. They had been ahead of expectations, but the shares sold off significantly and have only partially recovered.”

Short baskets

He points out that a number of the large brokerages, including Goldman Sachs and Merrill Lynch, put out AI short baskets, where their analysts sought to identify AI losers. 

These included media, education, jobs and recruitment, plus some software and IT services companies: “Goldman Sachs put out its basket, causing wobbles for WPP, Publicis and others. There has been some recovery since, but this is a new challenge for us as value-oriented managers.” 

In many cases, he believes, these problems may not materialise and they certainly need more nuanced reflection than simply assuming that whole sectors will be taken out by AI. 

“We don’t make snap judgments. We have initiated a review, trying to engage with corporates, with independent commentators, and to think about it in a different way. We want to understand, for example, timeline risk and the valuation context. WPP, for example, is already on a very low multiple. For a fund like ours, risks like these can become opportunities over time.” 

There is also the problem that AI has inflated valuations in the US market when it was already expensive. Financial News recently reported that net flows into AI and big data funds globally of €813m between January and the end of May. 

That is more than the whole of 2022. The Ireland-domiciled Xtrackers Artificial Intelligence & Big Data ETF gathered an additional €116m to the end of May, having seen net outflows of more than €40m in 2022.

Concentration risk

Fidelity’s chief investment officer Andrew McCaffery, warned: “Concentration risk in US equities is becoming very pronounced with the market hyped about AI and sanguine about potentially more Fed rate hikes.” The group believes there is a danger that AI fails to meet expectations, and the US markets – already expensive – loses its momentum. 

In this respect, the hype around AI may represent a risk to the wider market. It is not yet clear who will be the winners from AI and there are some snap judgments being made about the potential losers. 

The technology is still at an early stage and it is difficult to know whether it will live up to its promise, or whether its influence will start to ebb. 

In the meantime, it has made an expensive part of the US stock market look even more expensive. While earnings have generally been positive for the technology giants, particularly compared to their performance last year, recession is looming and valuations leave little room for disappointment. 

Artificial intelligence may be every bit as exciting as anticipated, but at the moment, the market needs to do its homework on the potential risks and rewards.  

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