Volatility may be part and parcel of equity markets, but this summer’s swings stand out. The causes cited for the sell-off included concerns over the outlook for the US economy and an unwinding of yen carry trades. Investors also worried about the risk of the vast sums being invested in artificial intelligence (AI) ultimately not generating sufficient returns. Daniel Morris investigates the AI angle.*
Return and expenditure have moved in sync
Many companies have been investing massively in artificial intelligence in the belief that it will prove transformative for their business. We do not know to what degree this will happen, but one should consider the track record of US technology companies in generating returns on investments. As capital spending has risen over the last decade, earnings have risen largely in line (see Exhibit 1).
We estimate that the major US cloud service providers could spend over USD 150 billion combined in 2024. If we include other mega-cap companies that are building out AI infrastructure, that number could eclipse USD 200 billion. That sum would represent more than 50% growth over 2023.
This investment is in sectors with significant potential for growth, including translation and computer code generation. The use of the models that underlie AI, however, requires significant investment in datacentres, where growth is expected to accelerate due to AI investment. AI servers could account for the majority of total server spending by hyperscalers – a type of large-scale datacentre that offers massive computing resources – in 2024, according to Gartner. It recently more than doubled its growth estimate for total information tech spending on datacenters in 2024 from 10% (in April) to 24% (see Exhibit 2).
Ultimately, though, the highest returns can be expected to be generated by those that can expand beyond the infrastructure layer and develop AI-enabled applications that become widely adopted.
Spotting opportunities in a high valuation segment
Even if earnings growth is expected to be good (consensus estimates for the tech-heavy US NASDAQ 100 index are for 17% average earnings growth over the next three years), valuations now look relatively high.
The current forward price-earnings ratio of around 26x is near the high end of where valuations have been over the last 20 years, though they are lower when the extreme levels of the late 1990s tech bubble are included. Valuations were as high as 48x in 2000, with outliers at more than double that level.
That increase in valuations reflects the increasing profit-generating capability of companies in the index. Return on equity has risen from 16% at the peak of the tech bubble to nearly 26% today – that warrants a higher valuation (see Exhibit 3).
This is not to suggest that valuations are not a concern. However, in our actively managed sector funds, we are still able to find stock-specific opportunities, even in industries such as semiconductors, e-commerce and software, where valuations are high.
At an index level, we do not believe valuations for the NASDAQ are extreme, particularly given the potential to grow earnings and free cashflow.
Admittedly, overall valuations may now look less compelling than they did over the past couple of years. However, we believe the tech sector deserves a premium valuation given that revenue growth is faster and cashflow generation stronger than for many companies in the broader market.
*With contributions from Pamela Hegarty, Portfolio Manager, Vincent Nichols, Senior Investment Specialist, US and Global Thematic Equities, and Derek Glynn, Associate Portfolio Manager.
