Outlook 2024: How to take advantage of AI without valuation risk
Be smart about your exposure to AI and avoid overpriced assets
Morningstar’s comprehensive 2024 Outlook report includes an exploration of how to take advantage of the impacts of AI, which Bill Gates has declared as revolutionary as the internet. The issue with many AI plays is that they have high levels of future growth already priced in. The report gives suggestions on how to gain exposure to this revolutionary trend without taking on valuation risk.
Artificial intelligence (AI) is widely expected to change the way business is conducted. Especially with the progression in generative AI. The pace of change is remarkable, with investors naturally eager to understand the winners and losers. While we’d warn investors not to let hype dominate their investment decisions, we are seeing a tremendous shift in the make-up of equity markets, which are worthy of note for all investor types.
The list of major players in the AI space are already household names. But valuations have increased significantly in anticipation of success. They have a first-mover advantage, although they are still subject to risk.
The AI opportunity entering 2024: Second-derivative plays
While the excitement surrounding the potential for artificial intelligence has boosted those stocks directly tied to AI, we think some of the more attractive undervalued opportunities are those that are second derivative plays on AI.
Here are four examples that we’d describe as second-derivative plays:
- Most companies do not have the expertise or financial wherewithal to build and maintain their own AI platforms. That’s where IT consulting companies could come in with technical capabilities in artificial intelligence services.
- Another example is data management providers that host enterprise data on which artificial intelligence models are run.
- AI requires extremely high speeds to train its data models and we expect those with the highest networking speeds to allow it to reap the benefits of spending brought on by investments in generative AI.
- Data centres will likely experience a long tailwind from the explosion of growth in AI. As AI is built, trained, and rolled out, it will require a great deal of computing power and data storage.
A focus on economic moats could be a sensible approach
Economic moats is a term that was popularized by Warren Buffett. The term refers to a sustainable competitive advantage that can protect and grow earnings over the long term and keep competitors at bay.
A competitive advantage that Morningstar’s equity analysts believe will last more than 20 years has a wide moat, one that will last more than 10 years is a narrow moat. We believe that this is one of the keys to finding superior long-term investments – buying companies that can stay one step ahead of their rivals. It signals strength and durability.
When we think about the AI trend, we are in a period where product development is in over-drive. It is a dangerous game to chase the early winners and lends to more risk in your portfolio with higher valuations.
Companies with economic moats could be more likely to benefit and may be less susceptible to disruption from AI than those without moats. Moats based on a combination of customer switching costs, unique data sets and brands could be particularly valuable.
Companies with durable advantages could use AI to improve their products and services and strengthen their competitive positions. On the other hand, change brought about by AI could erode companies’ economic moats or shift consumer demand away from their products and services. Investors should be on the lookout for permanent changes in industry structures and customer preferences.
In the end, stronger management teams who allocate capital effectively could influence better investment outcomes. Effectively integrating AI into existing products and services will be a complex endeavour for managers. Navigating new competitive threats will require sound strategy and solid execution. Moreover, managers may be tempted to overspend on AI-related product development or pursue ill-advised acquisitions. Consider investing in businesses whose managers have a track record of sensible capital allocation and effective execution.
Artificial intelligence is a theme that many investors are looking to jump on. We expect that the interest from the market will continue in 2024. Second-derivative plays offer an effective way for investors to access the AI theme without valuation risk. These are companies that can effectively embed AI into their workflow or drive new revenue growth opportunities.
Underpinning all of this, the fundamentals of successful investing still apply. Purchase quality investments at reasonable prices. Above all, investments that align with the financial goals that you are trying to achieve, and that conform to the stipulations of your investment strategy.
The 2024 Market Outlook report also explores the economic themes that will influence investments. It declares that portfolio construction must account for economic change – both expected and unexpected. Read about the three swing factors that could impact your portfolio here.
Is AI a risk to your retirement? Explore whether unintentional over-exposure will add unneeded risk to your portfolio.