AI – hype and hope?

Artificial intelligence has become so hot that any chief executive who mentions it in their plans is likely to see a decent pop in share price. It is even hotter than mentioning the metaverse was a couple of years ago – but maybe that is best forgotten.

Is the investment excitement around AI all hype and hope?

It is exciting, but it is not new to many investors. Specialist funds and ETFs in this space go back several years, long before 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 recognise its potential – and some of its limitations.

Investors still have to try to work out which companies might benefit

Even if we agree that AI is a big thing and that lots of people are going to do an awful lot of it, investors still have to try to work out which companies might benefit. Perhaps more importantly, are their shares worth buying? There is a difference. 

I always want to justify the price I pay for a share in terms of the cash that will eventually support it. This requires assumptions about costs, growth, tax and, with technology stocks, dilution from shares issued to “pay” management and staff. Analysts valuing tech stocks often do so based on sales revenue.

All these assumptions become strained, however exciting the growth story, when a share trades roughly above five times sales.

During the 2000 tech bubble, Sun Microsystems saw its shares run to $64 before crashing to $10. Co-founder Scott McNealy later challenged the valuation discipline of investors who had bought or held his shares at the peak, saying: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100 per cent of revenues for 10 straight years in dividends. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard for a company with 39,000 employees… assumes I pay no taxes… [and] assumes that with zero R&D for the next 10 years I can maintain the current revenue run rate… What were you thinking?”

Be wary...

Investors should be wary of “What were you thinking?” stocks in the AI universe. Some might argue that chip designer Nvidia has reached that status. Processing power appears to be the bottleneck in the AI boom, so Nvidia looks well placed to benefit. But the shares have trebled since last September on the AI story.

Following recent blowout results, Nvidia is valued at nearly $1 trillion and has upgraded sales expectations for this year to towards $40 billion. In other words, the company is priced at 25 times sales. Those sales could continue to grow rapidly with AI, but even if the company maintains its current margins forever, by my maths it would need to increase sales by around eightfold to justify the current share price.

When a share is valued on sales alone, the share price will of course react to sales upgrades. However, in the long run only cash profits will support a share price and in previous periods of excitement over new technologies it has paid to leave the party early.

Are there alternatives?

Nvidia is now “worth” nearly double the value of the world’s largest chipmaker. TSMC, which we own. It has $2.3tn of sales compared to a market value of $14 trillion, so is valued at a price/sales ratio of six. As TSMC makes Nvidia’s chips (Nvidia decided years ago to design but not manufacture chips) and the chips of most other AI beneficiaries, that would seem a cheaper alternative investment.   

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

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

We should consider Google and Microsoft too. Both have been working on their own chip designs for some years. Google is expected to use its own chips (called tensor processing units — TPUs) in its cloud servers from 2025. Microsoft’s Rapid Assured Microelectronics Processor design is already being used in the company’s Azure cloud by the US defence department.

These two companies (we hold both) have another advantage. At its core, what AI does is process data very quickly. But it needs that data, which is good for people who have lots of it. Google, for instance, has all the searches we have ever typed into it. Microsoft has its Bing search engine and is busy collecting data of its own. 

We hold another company that might benefit — Accenture, the world’s biggest IT consultant. Its clients are mainly companies whose in-house IT will need support in addressing the opportunities and challenges of AI.

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

This is a complex area. Invest with caution...

In the coming months, lots of different visions will be offered by people who are much more capable than me with a screwdriver and soldering kit. The technology will advance – how soon before next-generation graphene chips hit the market, offering 10 times the speed of today’s chips?

There will be several ways to play the theme. And it will be just as important to consider which of your shares could be undermined by the new tech – AI may destroy as many businesses as it creates.

It is good to have AI beneficiaries in your portfolio. But you should be careful with valuations – if relying on growth for a return, set realistic expectations. Hope is good but will not overcome all.