Being underweight the ‘Magnificent Seven’ would have made for a painful 2023. The seven US mega-cap technology stocks – Microsoft, Apple, Alphabet, Meta, Nvidia, Amazon, and Tesla – were collectively up 80% over the year, while the remaining 493 stocks that make up the S&P 500 index were relatively flat at around 5%.
The seven’s domination of the US market was in some part based on the boom in artificial intelligence (AI) and its future growth potential. However, some investors have started to question the sustainability of the lofty valuations at which the seven now trade – at an average price to earnings (P/E) ratio of 53 at the end of 2023, which is approaching the tech bubble levels of the late 1990s and early 2000s.
Investor caution may stem from the many false dawns in the tech sector over the ensuing 20-odd years. The all-encompassing potential of AI, however, leads me to believe that we are only just getting started when it comes to growth, but a broadening of stock performance away from the Magnificent Seven can be expected.
The pace of AI innovation over the past couple of years has been vast – as witnessed in the capabilities of OpenAI’s ChatGPT-4 model over its 3.5 predecessor. AI has the potential to influence all aspects of our lives, but the ramifications for the labour market are most hotly debated.
Goldman Sachs estimates that two-thirds of US jobs are exposed to AI automation. That doesn’t necessarily mean a mass cull of jobs. The adoption of AI could free an employee of the time-consuming and mundane elements of their job, allowing them to focus on the more creative, value-add parts.
That’s probably bad news for back office, administrative roles but good news for knowledge sectors. Productivity gains from the widespread adoption of AI are estimated by Goldman Sachs to be as much as 1.5 percentage points over 10 years, potentially boosting annual global GDP by 7%.
And widespread adoption could be achieved far quicker than previous general-purpose technologies. Electricity took 42 years to reach general adoption, the computer took 20 years and the internet 12 years – all due to differing barriers. These barriers of use are not prevalent with AI. Users need just a smartphone and the internet, which puts the technology in the hands of 6 billion people worldwide.
Workplace adoption is on the rise, too. According to McKinsey’s State of AI 2023 report, more than a third of organisations in the US are already using generative AI regularly in at least one business function. Meanwhile, between 30% and 35% of S&P 500 companies mentioned AI on earnings calls in the second and third quarters of 2023 – up from 10% to 15% during both 2021 and 2022. This indicates that AI is becoming a top priority among company executives.
More importantly though, mentions in earnings calls have historically tended to be followed by increases in company-level capital spending on that subject. For AI this could be vast. For large-scale transformation to happen, businesses will need to make significant upfront investment in physical, digital and human capital.
Significant spend on infrastructure is also required to support the mass adoption of AI. A substantial shift from general purpose computing to mass parallel processing (a large number of computer processors simultaneously performing a set of co-ordinated computations in parallel) is required to fulfil the needs of generative AI. An AI server is eight to 10 times more expensive relative to a cloud server, while five times more power is required.
This is why so many investors ploughed into the Magnificent Seven. Their lofty valuations (and differing roles in the AI revolution) and the size of the AI universe means a broadening of performance among the lesser-known AI beneficiaries should be expected this year.
This is certainly the view of Ben Rogoff, manager of the £3.3bn Polar Capital Technology trust. His conviction levels on AI are as high as ever and he has positioned the portfolio accordingly, with almost 80% exposed to the theme.
While the Magnificent Seven outperformed in 2023, Polar Capital expects a broadening of performance among mid- and small-cap AI beneficiaries this year. If this proves to be the case, the trust’s active management style could prove valuable after several challenging years.
The fund is substantially underweight Microsoft and Apple, while its largest overweight position is in semiconductor specialist Advanced Micro Devices. The company is set to benefit hugely as spend on AI infrastructure grows, with a total addressable market of $400bn. If the industry looks for an alternative source of processors and chips to Nvidia, it could certainly take the mantle.
Cybersecurity firms are also well placed. Concerns that AI will increase the arsenal available to cyber-criminals, with the scale and sophistication of phishing and impersonation-based breaches already on the rise, will likely result in increased cybersecurity demand.
The fly in the ointment for AI could be regulation. The potential impact on privacy and jobs plus intensifying debates around the ownership of copyright and IP may well result in strict regulation of AI. We have already seen the EU pass the AI Act and more government scrutiny is likely to follow.
However, what should act as a pacifier to burdensome regulation is that the US cannot afford to stifle domestic AI innovation given the stakes at play in the global AI race with China.
With AI still only in its infancy, technology stocks will undoubtedly continue to perform strongly. But while 2023 was dominated by the mega-caps, a broadening of performance among other AI beneficiaries could be the theme this year.
Richard Williams is a research analyst at QuotedData. The views expressed above should not be taken as investment advice.