An Off-The-Beaten-Path Guide To Finding AI Investing Ideas

An Off-The-Beaten-Path Guide To Finding AI Investing Ideas
Russell Burns

10 months ago5 mins

  • AI has boosted mega-cap tech and semiconductor stocks, but the hype has also pushed valuations to levels that look a little stretched.

  • If AI is really set to transform the economy, the boost to productivity and profit growth will be seen across many sectors of the economy, not just technology companies.

  • Increasing your portfolio’s exposure to the S&P 500 Equal Weighted Index, with its cheaper valuations and more balanced exposure to US stocks, could be sensible in this environment.

AI has boosted mega-cap tech and semiconductor stocks, but the hype has also pushed valuations to levels that look a little stretched.

If AI is really set to transform the economy, the boost to productivity and profit growth will be seen across many sectors of the economy, not just technology companies.

Increasing your portfolio’s exposure to the S&P 500 Equal Weighted Index, with its cheaper valuations and more balanced exposure to US stocks, could be sensible in this environment.

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The market’s AI obsession has driven Big Tech stocks sharply higher this year, leading some valuations to levels that look awfully stretched. It was enough to send tech-investing guru Cathie Wood for the exits: the Ark Invest CEO dumped shares of Nvidia, worried the chipmaker’s valuation was already unrealistically rich, long before the rally showed any signs of fading. So if you think stock valuations are starting to look tippy, but don’t want to miss the AI boat altogether, let’s take a look at where other opportunities might lie…

How’s this AI obsession playing out in markets?

Big Tech’s giants, with their robust business models, sustainable profit margins, and strong stock performances, have packed on muscle upon muscle, and now hold an outsized weighting in the S&P 500 Index. And that all started well before ChatGPT came along and got everyone hot under the collar about the possibilities of AI. Apple, Microsoft, Amazon, Nvidia, Alphabet, Meta, and Tesla account for nearly 27% of the stock index. This heavy weighting supports the performance of the S&P 500, but it also increases its valuation multiples. And by quite a lot.

See, the S&P 500 Index is trading at a 17x price-to-earnings (P/E) ratio based on next year’s earnings estimates, according to Bloomberg. That’s in line with the average multiple over the past 30 years.

But let’s compare that to the S&P 500 Equal Weight Index, which includes the same 500 stocks, but instead of weighting each by market cap, it assigns a fixed weighting of 0.2% to each company, regardless of size, and rebalances it at the end of every quarter. It trades at a more reasonable 13.5x forward P/E ratio. And that’s because its balanced structure dilutes the impact of the high mega-cap tech valuations.

Viewed another way: while the S&P 500 is up 9% this year (indeed, the even more tech-centric Nasdaq is up 23%), the S&P 500 Equal Weight Index is down 1.4%, as recession fears and higher interest rates drag down stocks from other sectors.

The recent AI-inspired rally in mega-cap tech has led the S&P 500 to a stunning outperformance over the S&P 500 Equal Weighted Index. Indeed, the Equal Weighted Index hasn’t fared this poorly against the overall index since the onset of the Covid crisis.

The S&P 500 Equal Weight Index vs the S&P 500 Index, five-year price ratio. Source: Bloomberg.
The S&P 500 Equal Weight Index vs the S&P 500 Index, five-year price ratio. Source: Bloomberg.

Sure, the high valuations for tech stocks may well be justified due to their strong growth outlook and advantageous positioning as the key early beneficiaries of the AI revolution. But, it’s still early days for AI and the train may just be leaving the station.

Goldman Sachs estimates that AI could lead to a 4% increase in profit margins over the next decade in the US, increasing earnings growth by 3% annualized. If AI fulfills its potential, it will be felt across a wide range of companies and sectors, not just the few tech giants that are currently leading the market.

What’s the opportunity?

There are several ways to potentially benefit from the dawn of AI transformation. Here are a few investment ideas worth considering:

If you think technology is the only sector that stands to really gain and can see these high valuations going even higher, then you might consider sticking with the purer-play single stocks like Nvidia, Advanced Micro Devices, Microsoft, and Amazon, investing directly, or maybe through the Invesco QQQ Trust Series (ticker: QQQ; expense ratio: 0.2%) or the iShares Semiconductor ETF (SOXX; 0.35%).

If you are already invested in the S&P 500 Index through a fund like the SPDR S&P 500 ETF (SPY; 0.095%), you could stick with that as a mega-cap tech stock play. On the other hand, if you’re concerned about the high valuations of those firms, but still want to maintain some exposure to them, you could consider switching some (or all) of your holding into the Invesco S&P 500 Equal Weight ETF (RSP; 0.2%). As the name suggests, it tracks the S&P 500 Equal Weight Index.

You might also consider an investment trust. The performance of these investment funds, which are traded on the London Stock Exchange, is driven not only by the underlying performance of the companies they invest in, but also by the supply and demand for the shares in the trust. And that makes them different from other funds as the shares often trade at a discount – and occasionally a premium – to their net asset value (NAV). And that’s where you could find opportunities.

See, when shares in investment trusts are in high demand, the discount often narrows. The Polar Capital Technology Investment Trust (PCT; 0.93%) is an investment trust focused on technology stocks. The fund holds 10% in both Apple and Microsoft, 6% in Alphabet, and 2.5% each in Samsung, Nvidia, and Advanced Micro Devices. You get the picture.

Polar Capital Technology Investment Trust net asset value, share price and premium/discount. Source: Bloomberg.
Polar Capital Technology Investment Trust net asset value, share price and premium/discount. Source: Bloomberg.

During the Covid crisis in 2020, when tech stocks were in high demand, the investment trust saw the share price discount to its NAV narrow sharply (red shaded area in lower panel) and even managed to trade at a premium (green shaded area in lower panel) for a few months. But it was relatively short-lived, and when tech stocks sold off last year, the discount widened again from around 7% to 13%, where it currently stands.

If tech stocks continue to rally, there’s the possibility that not only will the trust’s share price increase along with the value of its investments, but also the discount may narrow once again, offering improved returns. But it’s not a certainty: the discount to NAV could also remain stubbornly high even if tech continues to rally.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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