Let's take a few minutes to talk about AI stocks. Brook, when we last talked a few months ago, you walked me through a bunch of nonobvious ideas for AI investments. Are you still finding attractive things to buy, despite a big rally in the stocks?
Dane: First, as I've said, it's very early. We're in the emergence of this technology right now. The landscape is going to change dramatically over the next one, three, five years. Investors have to pay attention to how these things are changing and where opportunities emerge. The second thing is that, in general, there's going to be considerable differentiation between winners and losers. Right now, the obvious plays are the ones getting revenue today, the picks-and-shovels players, semiconductor components, and networking, and then the big cloud vendors.
We're at a funny moment, though, where the market has realized that there is going to be a boom in applications, and that there will be a bunch of infrastructure software that gets pulled along with this. There are exciting opportunities, but that isn't going to move numbers for calendar-year 2023. So, as long as your investment horizon is long enough, you're likely to see the payoff from this. If you're trying to manage a portfolio from now to the end of the calendar year, the companies that are seeing the benefit are the very obvious choices that have already moved, like Nvidia and Microsoft and Alphabet.
When Microsoft reported June-quarter earnings a few weeks ago, the market's reaction was a little tepid. The results didn't really reflect all of the things they have been saying are coming on the AI front.
Dane: As we've moved through this latest earnings period, you saw a lot of companies produce results that have been ahead of expectations or right in line with expectations. Nobody has particularly gotten aggressive about raising guidance, and stocks have sold off into that, because they had large moves into the end of the quarter through June and July. People were expecting some excitement. The excitement is coming in a lot of these names, but just not in the next 90 days.
Microsoft seems incredibly well positioned from our perspective, given what the company is doing with Copilot and Azure. For us, that seems like a compelling opportunity.
Give us a couple of other picks.
Dane: I'm bullish on Marvell Technology [MRVL], which makes chips used in data-center networking. It will grow right alongside Nvidia. Its AI-related business is around $200 million in revenue, and should double in each of the next couple of years. The stock has moved up, but so have estimates. This is a picks-and-shovels play, where the numbers are going higher.
Another company we like is Adobe, which dominates the creative software market. We've been hearing good things about the beta test for its corporate version of Firefly, Adobe's collection of generative-AI tools. From what we hear from the sales channel, the beta version is doing exceptionally well. One of the biggest advantages that Adobe software offers is that customers will be protected from copyright infringement for their text-to-image software. There's a little bit of TBD around how big this is -- we still don't have pricing information -- but this is one of those situations where the incumbent has an advantage.
And what about Nvidia?
Dane: We have owned it and continue to own it in our large-cap and tech-focused funds. But we're always managing risk and reward with position sizing; you want to make sure you stay in balance. As the leader in graphics processors, they are in a unique position -- they are really benefiting from this wave. The business will do exceptionally well, but valuation has a range of outcomes.
Mark, you wrote a piece recently that asked if we are in an AI bubble. Are we?
Moerdler: We've been in an expectation or optimism bubble. The investor community has gotten enthusiastic about the near-term revenue that's going to be generated by the technology. Again, this technology exploded on the market. Investors looked at it and went, OK, it's going to generate meaningful revenue in a relatively short period. Expectations moved up, and valuations moved up accordingly. Many management teams started talking about their AI solutions. You could literally watch stock valuations move up the more they talked about AI, even though they weren't giving you any guidance about when and how much. We've seen multiples move up to relatively high ranges, approaching what we've seen at peak multiples in recent times, without that line of sight to the revenue-generation possibility.
And so from that perspective, there is a bit of a bubble going on. It's going to take longer than many people believe for AI to drive meaningful revenue. That doesn't mean no revenue, but enough to move the needle from a revenue growth perspective or an earnings perspective. It is likely that in most cases, revenue is going to lead earnings here because there's a lot of investment required to offer AI tools. You're using them in the cloud. You're paying for that usage, even if you own it yourself. You're probably paying a premium right now, because of the GPU [graphics processing unit] shortage. And so, yes, we got a little bit ahead of our skis.
I also don't think the rising tide will lift all ships equally. It's going to come down to the companies that are able to create differentiated capabilities, protected against competitive threats -- and that have the ability to monetize them. A lot of companies are going to add AI capabilities, and it is going to be, at least in the near term, a cost of doing business. It isn't going to be monetizable because your competitors are going to add similar capabilities.
As Brook discussed, you need to think about the time horizon. We think of three buckets. There are the companies where you can see differentiation in what they're offering now. There are companies that are adding AI, but it may just mean a higher cost of doing business, at least for the near term. Longer term, years from now, it could become real. And then there are the companies that will be disrupted. Most companies are in that middle bucket today.
Which companies would be in the first bucket? And the last?
Moerdler: Two of the companies that I put in the winners bucket were just mentioned by Brook -- Microsoft and Adobe. I put in the losers list companies offering no-code and low-code software solutions; they are going to face new competition from AI-written code. For the losers, we see a combination of increased customer attrition and pricing pressure. Almost everything else is the middle bucket. For most companies, generative AI won't be a major differentiator but will be necessary from a competitive positioning perspective. Most of these are jumping on the AI bandwagon, and while they should be able to get functionality to market quickly, it won't be differentiated and, in many cases, really valuable to customers.
Dane: One thing to note: The opportunities in tech companies are compelling right now, with AI as an option in front of them. Business fundamentals are largely stable. The economy is in better shape than we all thought it would be six or nine months ago. These companies have largely pivoted to driving cash flow and operating income instead of chasing growth for growth's sake. And then you have this optionality around AI.
Moerdler: Agreed. If your focus is on the value of the business, and the upside from AI, you're going to get better a risk-reward in terms of your investment profile than if you jump on the all-about-AI ship, because it may just take longer until that revenue comes to fruition.
While tech stocks have had a big year, and everyone is talking about AI, there haven't been any AI initial public offerings, or really any IPOs in tech. Cathy, what does that say about where we are in the development of the AI sector?
Gao: When the general IPO markets will unfreeze for tech is the million dollar question. I have no idea. In any case, it's going to take a while before we see pure-play AI companies come public. The speed of adoption that we're seeing in this cycle with AI has outstripped anything that I've seen in prior platform shifts. But maybe there's something we can learn from the internet revolution that could be applied to the current era. In the internet era, the first wave of companies that came out weren't the ones that ultimately succeeded. It was more the second wave and the third wave that watched their predecessors, learned from their mistakes, refined, rehoned, and went out. My gut is telling me that this is going to take a while.
Everyone, thanks for a fascinating conversation.
Write to Eric J. Savitz at eric.savitz@barrons.com
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(END) Dow Jones Newswires
August 20, 2023 18:18 ET (22:18 GMT)
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