Is the recent tech rally the real thing or an AI bubble? Jamie Mills O’Brien, Investment Director, abrdn, considers the facts.
Tech investors had an unforgettably rough ride last year, but at time off writing, since the start of 2023, the Nasdaq – a US technology exchange – is up almost 40%. The sudden arrival (in the consumer space at least) of artificial intelligence (AI) adds another layer of complexity to the analysis. And that’s without factoring in the political, regulatory and societal concerns around this new technology.
We may have entered 2023 with concerns for almost the entire sector, but what we’ve seen so far is that Tech-sector fundamentals have enjoyed a strong start, driving resilient performance from software to digital advertising, and across internet and payments companies. Some 75% of technology, media and telecomms companies have beaten their sales and earnings forecasts.
The key question now is, will this tech rally last?
The boom in AI is undoubtedly the driving force behind the current rally in tech stocks following the speed at which consumers have adopted this new technology. In 2006, it took Twitter two years to get to one million users. It took Instagram 2.5 months to achieve one million users in 2010. ChatGPT however, took only five days to reach this milestone. It’s not yet clear whether businesses, in addition to consumers, will adopt the technology as quickly, but it’s easy to see why investors are excited by the sector. Companies, from consumer internet to manufacturing firms, are trying to get their hands on the kit needed to accelerate their AI strategies. This is happening fast and there simply isn’t enough to go around.
Nvidia has become the current ‘poster child’ for the sector’s earnings bonanza, having delivered an historic quarter. Indeed, analyst forecasts weren’t just wrong, they weren’t even in the right postcode. Nvidia enjoys a quasi-monopoly on the microchips essential to training AI models, contributing to the huge rise in share price recently.
Understandably, there has also been much concern around an AI-driven technology ‘bubble’ and investors have scrambled to group tech companies into ‘winners’ and ‘losers’ because financial markets love binary dynamics as they try to simplify something that’s likely to be far more complex and nuanced.
Don’t ignore the fundamentals
But before we decide whether this is a bubble or otherwise, it’s crucial not to ignore the fundamentals. As one tech investing expert, Gavin Baker, has noted: earnings revisions drive performance over the short term. Duration of growth and changes in return on invested capital, drive relative performance over longer time frames.
Despite weakness in key end markets, Nvidia is not the only businesses to be enjoying a strong year so far. Returns on invested capital in the semiconductor sector have been rising over the last decade, driven by industry consolidation and the diversification of demand. Companies such as Dutch firm ASML and the Taiwan Semiconductor Manufacturing Company are well positioned to reap the benefits of the boom in AI.
Over time, semiconductor-market growth has diversified away from highly-concentrated sources – personal computers and then mobiles – and towards a more diverse range of chip users that includes automobiles, datacentres and industrials.
If AI is likely to be in increasing demand across a diversified number of areas – and the data so far would suggest that it will be – then this will represent another, very material driver of returns.
Recent research by Goldman Sachs – Anatomy of a Bubble – identifies three key indicators: an asset class or technology that’s new and poorly understood (take cryptocurrencies for example); something that’s seen as the ‘next best thing’; plus, a period in which equity returns are driven more by speculative behaviour than changes in earnings prospects.
So how does AI measure up? It is certainly a new asset class and, for the moment, there seems to be consensus that it might be the ‘next big thing’. Significantly, however, share-price multiples haven’t universally expanded beyond earnings estimates.
For example, Nvidia’s earnings estimates are up more than 75% this year. Meanwhile, some of the biggest technology stocks are generating sales growth at some five times that of the rest of the market and with margins that are twice as high. The technologies critical to AI are also far more mature than for corresponding technologies at the centre of previous ‘bubbles’.
This AI moment likely represents a ‘sustaining innovation’ given its heavy reliance on data and advanced processing, which puts the advantage in the hands of those companies with the breadth, engineering capacity and capital to design the silicon wafers and harness the data required to execute at scale. Whisper it, but perhaps this ‘bubble’ could be more fundamental in nature than speculative.
Ultimately, any investment strategy that relies simply on buying and holding the largest companies is likely to underperform over time. Some of those companies will, of course, thrive. But they will be few and far between. Investors will be successful if they can invest in the rare companies that can harness this technology to drive scale and returns.
There will likely be more ‘Nvidia moments’, as the pace of technological change accelerates and, with growth an increasingly scarce phenomenon, there will to be a premium for those firms able to capitalise on this new technology shift.
