AI stocks post big gains in Q3. These are the winners and losers
Alphabet and Teradyne post big gains, while Salesforce and Adobe were down in the quarter.
Artificial intelligence stocks extended their blockbuster gains in the third quarter amid continued heavy investment in the technology. A basket of 38 AI stocks selected by Morningstar equity analysts rose 15.7% in the quarter, which followed a 27.3% surge in the second. The third quarter’s gain doubled the 7.7% return on the overall stock market, as measured by the Morningstar US Market Index, and it was ahead of the 11.7% return on the Morningstar US Technology Index.
Leading contributors to the rally included Corning GLW, up 53.3%, and Teradyne TER, which advanced 49.5%.
Of the 38 stocks in the basket, 25, or 66%, outperformed the market during the quarter, with 15 rising more than 20%. The majority of the outperformers were in the technology sector, with a couple of others dispersed across communication services and industrials.
With this rally, the AI basket now trades at a 16% premium to Morningstar’s fair value estimate of the average stock in it.
The AI stock basket
The Morningstar equal-weighted basket of 38 stocks aims to represent a cross section of the AI universe. The largest portion is allocated to hardware firms involved in building or supporting AI server infrastructure, such as Taiwan Semiconductor Manufacturing TSM. Next-largest are the hyperscalers, included for their cloud businesses, product-level AI integration, and internal infrastructure development. These include names like Amazon.com AMZN. Finally, there are select software firms that could benefit from advancements in AI, such as Salesforce CRM.
The best and worst performers in the Morningstar AI basket
There were clear winners and losers among AI stocks. Here are the five best-performing stocks from the AI basket in the quarter.
Among the best performers were Corning, up 53.25%, Teradyne, up 49.54%, and Arista Networks ANET, up 40.13%. According to William Kerwin, senior equity analyst at Morningstar, all three benefit from buildouts of AI data center infrastructure. For Corning, the connection is optical fiber, Teradyne with chip testing equipment, and Arista for network connectivity equipment. “Across these stocks, we see Corning and Arista as overvalued, and Teradyne as fairly valued.” says Kerwin.
Another AI leader in the quarter was Alphabet GOOG, up 37.88%. Morningstar equity analyst Malik Ahmed Khan says the outcome of the Google Search antitrust case was a significant factor in the rally: “The case has been hanging over Alphabet’s head. With this ruling, investors can breathe a sigh of relief, knowing that US District Judge Amit Mehta did not propose structural remedies that could have been value-destructive.” He believes Alphabet can focus more on its Search business while aggressively integrating AI features. “We now view Alphabet as fairly valued, with the stock up more than 50% from its April lows,” he says.
One non-US name landed among the top performers: Samsung Electronics 005930 rose 40.8%. The stock currently trades at a 17% premium to its fair value estimate.
While it was overall a strong quarter for AI stocks, seven of the 38 finished the period in the red, including several high-profile names. Salesforce lost 9.96%, ServiceNow NOW fell 8.48%, and Adobe ADBE dropped 7.1%. “Software in general totally rolled over in July and has been weak through early September.” explains Morningstar senior equity analyst Dan Romanoff.
The rise of generative AI and increasing competition have put Adobe under pressure. “There are fears around the impact generative AI will have, and low-end competitors caught Adobe off-guard a few years ago, and the company has been playing defense,” says Romanoff. He says that while Adobe now has a firm footing in the affordable segment of the market with Adobe Express, competition continues to ramp up as stocks such as Figma FIG provide diversity in the market. “Investors have an alternative vehicle in the creative/design software space that they haven’t had in 15-20 years,” explains Romanoff.
With Salesforce, generative AI is seen as posing a major threat to the company’s core business. “Customer service is likely to be one of the first areas affected by generative AI,” says Romanoff. With 20% of Salesforce’s revenue coming from Service Cloud, he says the potential erosion of its seat-based model is leading to skepticism about the stock.
Adobe and Salesforce trade at a discount to their fair value estimates, while ServiceNow is considered fairly valued.
AI Stock valuations
While the rally lifted holders of these stocks, the gains are also inflating valuations. The average price/fair value estimate ratio rose to 1.16 during the third quarter from 0.99 at the close of the second. This means the average stock in the AI basket now trades at a 16% premium to its fair value estimate.
