Why This Tech Rally Might Be The Real Thing

Suppose that you've never read Frank Herbert’s epic science fiction saga, Dune, have never seen the trailer for the impending film, Dune 2, and don't have a working knowledge of the Bene Gesserit (a secretive female religious order). In that case, the quote forms the start of a powerful incantation used to provide clarity and perspective when facing mortal danger.

Now, fear is clearly not the most obvious way to characterize technology markets currently. The Nasdaq Composite – a key US technology index – is up almost 40% this year.

However, amid lingering cyclical fears, the sudden arrival (in the consumer space at least) of artificial intelligence (AI) adds another layer of complexity to the analysis. That’s notwithstanding the political, regulatory, and societal concerns around the broader impact of this new technology.

Clarity – induced by an "ancient" incantation or otherwise – is most welcome right now.

The investor’s incantation

It’s time to introduce another, far more powerful (for our purposes), incantation. Riffing this time on Gavin Baker’s popular technology blog, it’s this:

"Earnings revisions drive performance over the short term. Duration of growth and changes in return on invested capital (ROIC) drive relative performance over longer time frames."

How does tech shape up (Part 1)?

To address the first part of the Baker-inspired mantra – the reasons behind short-term performance –technology-sector fundamentals have, in fact, been very strong so far this year. Some 75% of technology, media, and telecom (TMT) companies have beaten their sales and earnings forecasts.

Having entered 2023 with concerns for almost the entire sector, what's actually happened has been resilient performance from software to digital advertising, to internet and payments.

Artificial intelligence

One company has become the poster child for the sector’s earnings bonanza: Nvidia. A firm with a quasi-monopoly on the microchips essential to training AI models, it's delivered an historic quarter.

Analysts’ forecasts for the firm weren’t just wrong, they weren’t even in the right zip code. As a result, Nvidia’s share price has seen a meteoric rise this year.

Nvidia sits at the heart of this year’s AI boom. Companies, from consumer internet to manufacturing firms, are trying to get their hands on the kit needed to accelerate their AI strategies. This is happening fast and there simply isn’t enough to go around.

Consumer adoption of AI technology has been stunning. In 2006, it took Twitter two years to get to 1 million users. It took Instagram 2.5 months to achieve 1 million users in 2010. However, ChatGPT took only five days to reach this milestone. The question now is whether businesses, in addition to consumers, will adopt this technology as quickly.

Now, there have also been plenty of concerns about an AI-driven technology bubble and investors have scrambled to group tech companies into winners and losers. Financial markets love binary dynamics as they simplify something that’s likely to be far more complex and nuanced. AI is no different. But before deciding whether this is a bubble or otherwise, let's return to the fundamentals and repeat again, "duration of growth and changes in ROIC drive relative performance over longer time frames."

How does tech shape up (Part 2)?

This second part of our self-labeled "investors incantation" will be the key determinant of longer-term stock market returns.

Areas of semiconductors (not just Nvidia) have been extremely strong this year despite weakness in key end markets. ROICs in the semiconductor sector have been rising over the last decade driven by two broad forces:

• Industry consolidation
• Demand diversification

AI is more relevant to the second factor. Over time, semiconductor-market growth has diversified away from highly concentrated sources (like PCs and then mobiles) to a more diverse range of chip users – including automobiles, data centers, and industrials.

If AI is likely to drive higher demand across a number of areas – and data so far would suggest that it will – then that will represent another, very major driver of returns.

Anatomy of a bubble

A recent piece of research by Goldman Sachs identified three key indicators of a bubble:

• An asset class or technology that’s new and poorly understood (think: cryptocurrencies)
• Something that’s viewed as the "next best thing"
• A period in which stock returns are driven more by speculative behavior than by changes in earnings prospects

AI is certainly a new asset class and, at the moment at least, there seems to be a general consensus that it might be the next big thing. Significantly, however, share price multiples haven’t universally expanded beyond earnings estimates.

For example, Nvidia’s earnings estimates are up more than 75% this year. Meanwhile, some of the biggest technology stocks are generating sales growth at some five times that of the rest of the market, and margins that are twice as high.

The technologies critical to AI are also far more mature than the corresponding technologies at the center of previous bubbles. These technologies provide the foundation that will allow some companies to scale up and become profitable much quicker so that ROICs will likely be higher for these firms versus previous disruptors.

It’s also likely that, in some parts of the market, the winners will keep on winning. Clayton Christensen, the "guru of disruptive innovation", grouped technology change into "sustaining innovation", in which incumbents become stronger, and "disruptive innovation", where incumbents become weaker.

This AI moment likely represents a "sustaining innovation" given its heavy reliance on data and advanced processing, which puts the advantage in the hands of those companies with the breadth, engineering capacity, and capital to design the silicon wafers and harness the data required to execute at scale.

That’s perhaps also what separates this from an "iPhone moment" – a disruptive force that made it very challenging for incumbents (for example, Nokia) to respond despite its 53% market share in mobile handsets at the time. Whisper it – but perhaps this bubble is more fundamental in nature than speculative.

Final thoughts

Ultimately, any investment strategy that relies simply on buying and holding the largest companies is likely to underperform over time. Some of those companies will, of course, thrive. But they will be few and far between.

Investors will be successful if they can access and invest in those rare companies that can harness this technology to drive scale and returns.

There will likely be more "Nvidia moments", as the pace of technological change accelerates, and, with growth an increasingly scarce phenomenon, there will be a premium for those firms that are able to capitalize on this technology shift.

For investors, both incantations may yet prove to be invaluable.