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Picture: 123RF
Picture: 123RF

By mid-October the total return of the S&P 500 index was 14%, of which the so-called Magnificent 7 index accounted for 87%. One of the major attractions of these stocks is the “AI story”, as each has either a direct or indirect role to play in this rapidly ballooning field. They are Nvidia, Tesla, Meta, Apple, Amazon, Microsoft and Alphabet.

No wonder that investors are excited by these shares given the huge potential of this transforming technology. The artificial intelligence (AI) market is projected to reach nearly $420bn by the end of 2025, a growth rate of more than 45% per annum over the first half of this decade, and nearly $2-trillion by 2030. Though this is a slowing of its growth rate to 35% per annum over the second half of the decade, that is still remarkable.

In terms of the adoption of AI in various sectors and its potential, at the end of  2024 adoption is expected to be only at about 16% in the major sectors it is set to affect. These include tech and telecom, consumer goods and retail, financial services, and healthcare and pharma. As such, there is still plenty of room for growth.

While AI has been around for a while, Microsoft put it in the spotlight by investing $10bn in OpenAI in January. It then purchased an exclusive licence to the underlying technology behind ChatGPT3 and has now released its AI assistant Microsoft 365 Copilot, which leverages the capabilities of OpenAI’s large language models to integrate with an organisation’s data. 

AI investment opportunities

When we look at AI as an investment opportunity we group companies into three buckets. These are the “enablers”, or firms involved in software, the internet and semiconductors; followed by the cloud and data centre companies; and lastly the “adopters”, which provide services that use AI. 

Enablers include Adobe, Cadence and Nvidia; cloud and data centre companies include Amazon, Microsoft and Alphabet; and examples of adopters are Accenture, Tencent and Tesla.  Currently 33% of the Stonehage Fleming Global Best Ideas Equity Fund has direct exposure to AI related businesses.

In selecting which company to invest in candidates must excel on four critical dimensions. As we only invest in the best of the best we must understand which of our candidates is most likely to be the category winner on a sustainable basis. The critical investor considerations are:

  • Innovative expertise. The ability to attract and retain talent is paramount in this highly competitive industry, which is being built by electrical engineers from around the world. The right incentives are crucial, with stock based compensation being key. In addition to engineering talent, companies need to have financial disciplines in place. For example, the two founders of Google, Larry Page and Sergey Brin, appointed a CEO as well as an experienced CFO so they could continue to do what they do best: develop their technology.
  • Computing capacity. AI requires enormous computing capacity. As Google is directly involved in developing supercomputers it has an edge on this critical consideration.
  • Data quantity and quality. AI is based on data. Without the data companies are stymied. Data quality is also paramount because if the data isn’t right AI gives you the wrong answer.
  • Regulation/security. How is your candidate investment thinking and leading around regulation and security issues, and are there any developments on the horizon that could put your candidate at risk?

Our investment strategy also incorporates four critical, overriding, fundamental considerations to assess the quality of the individual business. We need absolute conviction on each of these “quality pillars” to take the candidate forward. 

  • What is the businesses’ sustainable, organic growth potential over the longer term? Without a good level of sustainable, organic growth the earnings, and therefore the share price, cannot grow sustainably.
  • What is the quality of management? We need conviction on the overall business culture and thus its ability to organise the business for sustainable growth.
  • How efficient has the company been over time in achieving a sustainably good operating margin and return on investment, along with a very strong balance sheet?
  • And finally, what is the company’s track record in converting earnings into free cash flow, as this is the only real return a shareholder can claim from the business and is thus important in determining the actual value of a business.

In conclusion, keeping up with AI technology takes a team of highly committed and focused analysts to ensure one identifies a sustainable business at an attractive price.

For those who do not enjoy that capacity, Accenture is a conservative way to get AI exposure. A world leader in helping businesses deploy the right technology, it has strong expertise in, among others, the cloud, data centres and AI services.

The firm already works on more than 300 projects for clients that need to deploy AI in their businesses. As its success depends on harnessing these capabilities for their clients, an investment in Accenture is one way to gain exposure to AI with materially less risk of picking the wrong share.

• Smit is head of equity management at Stonehage Fleming.

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