Generative AI: Finding Undervalued Investment Opportunities

Excitement about AI stocks like Nvidia has driven P/Es in the sector higher in recent months. In mid-July, ahead of the selloff, the PHLX Semiconductor Index, or SOX, traded at 34 times forward earnings—57% higher than the S&P 500’s average multiple, according to FactSet data. Financials and information tech comprise 42% of the S&P 500 Index by weight, with tech representing 29 percentage points of that figure. In fact, six out of the top seven positions in the S&P 500 by weight are currently in the tech sector. Are there ways to invest in the sector that are less pricey and can diversify the risk?

The Rapid Growth and Disruptive Potential of AI Technologies

Generative AI is in a very exciting part of the information technology market, as many experts believe it’s set to disrupt and transform companies and industries all the way from finance to health care and even to creative endeavors. AI is a once-in-a-decade computing platform shift akin to the transformations brought about by the advent of the internet, smartphones, or even cloud computing. Stanford University estimated global AI revenue in 2021 at around $91 billion, a figure that grew to $267 billion at the end of 2023 and is projected to exceed $1.8 trillion by 2030. As such, it’s no surprise that investors believe AI has the the potential to be quite disruptive, resulting in shifts in consumer habits and behaviors and even altering business models.

Parsing the investment opportunities created by the advent of AI in various sectors of the global economy favors a deep fundamental research process to identify and evaluate the potential winners and losers of this emerging trend. We see companies embracing AI because of the potential productivity benefits. In a world with over one billion knowledge workers who spend around 25% of their time on tasks that can be improved or automated with AI, the boost to productivity will be immense.  Tech giants and forward-thinking enterprises across finance, healthcare, and logistics are spearheading AI deployment and investment, with early adopters already reaping productivity gains from generative AI technologies.

For instance, call centers are implementing AI-powered chatbots and voice assistants, significantly reducing operational costs while improving customer service efficiency. Similarly, in the software development field, AI coding assistants are enhancing programmer productivity by automating routine tasks, suggesting code completions, and detecting potential bugs. These examples demonstrate how AI is not only improving efficiency but also transforming traditional work processes across various industries.

U.S. Productivity Escalated in Q1 2024 with AI and That Is Only the Beginning

Source: BEA, BLS and Piper Sandler & Co Research

While much investment attention is focused on AI applications, it’s crucial to recognize the opportunities in the underlying technologies that enable this revolution. The semiconductor industry is a critical building block in this regard. We project that major tech companies and cloud service providers will invest over $1 trillion in capital expenditure over the next five years, with a material portion directed towards AI-related semiconductors.

Historically, the early stages of technological shifts benefit companies that provide essential infrastructure. For instance, Cisco and Sun were pioneers during the internet’s early days, while Qualcomm, Nokia, and Ericsson led the smartphone revolution. Following this pattern, we view semiconductors as the cornerstone of the AI revolution — analogous to the picks and shovels of a modern-day gold rush. These components will form the essential foundation upon which AI technologies are operated.

AI Is the Once-in-a-Decade Technological Platform Shift

Source: Thornburg

International Opportunities Abound in the AI Development Stack

Our comprehensive analysis of the global semiconductor supply chain revealed numerous attractive investment prospects.  Many investors overlook the crucial role of international companies in this technological revolution. These include chip designers, semiconductor fabrication plants, specialty equipment manufacturers, and firms specializing in chip assembly and testing. Each of these players contributes significantly to the semiconductor ecosystem, helping to power the engine of AI innovation.

Not All the AI Winners Are in the U.S.

Source: Bloomberg

Savvy investors who are looking beyond the household names in the U.S. will find hidden gems throughout the international supply chain in countries such as Japan, Taiwan and Korea and the Netherlands. We found an international company, Disco, and a SMID company, Vertiv, that have managed to outperform Nvidia over the past few years.

There will be more opportunities on the investment horizon as companies become more sophisticated deployers and users of AI.  At the beginning of 2024 there were estimated to be approximately 70,000 AI companies worldwide, with only around one in four AI companies based in the U.S.

Small- and Mid-Cap Companies Benefitting from AI Investment

The initial focus within generative AI has primarily centered around select mega-cap players. However, as businesses across sectors increasingly consider how to utilize the technology effectively in their operations, we see ample opportunities for small—and mid-cap segments of the market poised to provide many of the products and services necessary to support a rapidly expanding AI ecosystem.

Here are a few of the themes and companies we are following in the small- and mid-cap space:

Connectivity: Generative AI, along with wireless 5G and video streaming, is creating a surge in global data creation. The effectiveness of these applications relies on the ability for increasingly large volumes of information to be shared instantaneously. Reliable connectivity is critical, and companies like Credo Technology are producing a variety of high-speed solutions that help data centers increase bandwidth and better enable information to travel quickly and efficiently over the internet and through large computer networks.

Memory Storage: The proliferation of information being driven by generative AI not only requires increased data storage capacity, but also more complex storage solutions. Flash memory storage, which uses electronic circuits to store data, allows faster access than traditional computer hard disk drives, which is critical for the real-time processing needs of many generative AI applications. Pure Storage is a leader in flash storage solutions tailored to the need of large-scale business environments. This company enables customers to consolidate their data storage more efficiently and is well positioned to disrupt the hard disk drive market.

Thermal Management: The processing needs of generative AI applications require significant computing power, and the heat generation from AI chips can be several factors of magnitude higher than from traditional computing. As AI technology continues to evolve, thermal management is critical to ensuring the safety and efficiency of data center equipment. Vertiv specializes in designing and producing heat management and humidity control solutions for data centers. As AI-related needs continue to pressure infrastructure, the next wave of AI investment should be a major catalyst for companies like Vertiv.

Ultimately AI will become a new tech platform similar to the Cloud or Internet. On this foundation, all sorts of infrastructure and services will be built. By anticipating these developments and how spending is set to evolve, we seek to invest in companies crucial to enabling an AI-driven future. They won’t all be large cap and born in the U.S.A.