The value investor's guide to AI (and 6 stocks to watch)

This article first appeared in Livewire markets on 15 February 2024

The MVP of 2023 was undoubtedly Artificial Intelligence (AI), which drove the stellar returns of big tech. It’s only just getting started – we’ve only seen the proverbial tip of the iceberg in terms of what AI is really going to mean and achieve.

It’s clearly the space to be for investors looking for big growth – but if you are a value investor, where do you look?

After all, The Magnificent Seven are trading at premium valuations, with concerns that some of the cohort are even overvalued. 

Further to this, AI’s potential is largely whispers and dreams in the testing stage, which adds an extra element of challenge to those trying to establish valuations across the industry.

I recruited two experts to find out their views on value investing in AI and where they are looking – and it turns out, there’s a lot to like in the market.

  • Sally Fang, Swell Asset Management
  • Casey Mclean, Fidelity International

The potential of the AI space – and how to segment the industry

While we’re all having fun with ChatGPT and Google Genesis, the breadth of AI is truly incredible. Fang points out that AI shows all the characteristics of previous pervasive innovations – every single sector and aspect of life will be touched.

One thing she notes in particular is the economic impact of using AI in the workforce from productivity gains.

“One area of early testing where companies have used AI is coding and there’s been 30-40% productivity gains. Goldman Sachs did a report forecasting out a 3% productivity gain each year from AI,” Fang says.

The pace of progress has also accelerated.

“In 2019, forecasters predicted it would take 80 years to get to the idea of artificial intelligence. In 2020, it was down to 30 years. In 2022, experts were starting to tip 2027 timing for artificial general intelligence (AGI),” she says.

For the unfamiliar, AGI refers to the ability to learn, interpret and apply knowledge across a broad spectrum – it’s next-level AI, where the cognitive ability is human-like.

Given how broad the AI theme really is, Mclean breaks it into three categories which he terms ‘the picks and shovels’, ‘the enablers’ and ‘the adopters’.

“The picks and shovels are the semiconductor and cloud companies developing the hardware that powers AI functionality. Often in the early stages of a gold rush, it is the suppliers of the picks and shovels rather than the gold miners that make the most profit.

The enablers are the software companies that are developing AI functionality into their products. The key to success here is owning unique datasets that can be manipulated to deliver genuine benefits for their customers.

The adopters are companies in traditional industries that can harness the power of AI to improve their competitive advantage. Sectors like healthcare, finance, and professional services such as lawyers have significant opportunities to improve efficiency and increase revenue,” he says.

"The adopters are companies in traditional industries that can harness the power of AI to improve their competitive advantage. Sectors like healthcare, finance, and professional services such as lawyers have significant opportunities to improve efficiency and increase revenue.”

Casey Mclean, Fidelity International and Sally Fang, Swell Asset Managemen 

Casey Mclean, Fidelity International and Sally Fang, Swell Asset Management 

Hunting for value in the biggest tech theme of our time

Last year, Barrow Hanley’s Cory Martin shared that value investors could still find access by thinking outside the square.

“We have to be very careful and smart about where we’re going and find opportunities involved in areas of these businesses that we’re almost getting the trend for free. That’s a classic value play,” Martin said in that interview.

He cited two examples of industrial companies on this front. One was the biggest provider of liquid cooling systems for data centres and the second was a leader in radar and sensors – thus connected to the growth in autonomous driving.

Mclean shares this view.

“The value in AI lies in the traditional “old world” companies harnessing for their own advantage,” he says, giving examples of healthcare companies automating diagnostics, finance companies using AI for fraud detection and retailers creating dynamic pricing for inventory management.

“Those that harness AI’s capabilities better and earlier than their competitors stand to win in the long term.”

Fang suggests investors hold to the traditional value approach – competitive moats that are hard to replicate, industry leaders trading below intrinsic value – but add the additional element of looking for under-appreciated AI structures where a company has multiple avenues to deploy and benefit from AI (and is beginning to do so).

Could The Magnificent Seven still be a value investment?

Fang believes that value investors shouldn’t shy away from The Magnificent Seven, despite their high valuations.

“If you just look at high P/E multiples compared to historically, you might say these companies are overblown but it’s different times and the pace and impact of what AI can do is still underestimated,” she says.

According to Fang, many of The Magnificent Seven still look promising based on fundamentals like Return on Invested Capital, Return on Equity, cashflow and in terms of how they are investing in technology ahead of the curve. They can keep spending strategically.

“These companies are enabling AI technology and infrastructure. They have strong fundamentals with robust earnings growth and competitive advantages that are not replicable. Taking a value approach, some of these companies are still trading below their intrinsic value,” Fang says.
Fang’s top pick from The Magnificent Seven is Amazon (NASDAQ: AMZN), arguing that the market underestimates its AI potential. It has an unrivalled fulfilment, the broadest cloud footprint of any business and is trading on decent multiples.

Mclean agrees that there are still high-quality prospects in The Magnificent Seven, but some are starting to see their competitive advantage fade, like Tesla (NASDAQ: TSLA). Nvidia (NASDAQ: NVDA), which is trading on a similar multiple, is a different story.

“Nvidia has a near monopoly, a huge technology lead over their competitors and a rapidly growing industry. Nvidia’s GPU margins are rising fast as supply struggles to meet demand leading to rising margins and returns,” he says.

Beyond The Magnificent Seven

Whatever your feelings in terms of valuations in The Magnificent Seven, investors could do worse than look outside these for opportunities.

Fang likes (NYSE: BKNG) and Advanced Micro Devices (NASDAQ: AMD).

“ have the opportunity to change the travel space and has been in the process of digitising the customer travel experience booking experience. They have access to millions of customers and can augment the experience with AI. Internally, they can also leverage AI to improve their coding productivity, customer service support and other administration,” Fang says.

AMD’s main revenue comes from selling chips. While they aren’t in the leading position, they benefit from supply constraints on Nvidia and Fang notes it has multiple ways beyond chips to benefit from the AI-boom, such as its infrastructure.

Mclean views ASML (NYSE: ASML) and SK Hynix (KRX: 000660) as good long-term international buys.

In fact, he calls ASML the most important company in the world, as the only supplier of EUV (Extreme Ultra Violet) lithography tools required to produce semiconductor chips.

“Without this equipment, ASML’s customers like TSMC, Samsung or Intel would not be able to produce the leading-edge chips pioneering the AI revolution, or even the best chips powering your smartphone, PC or car,” McLean says.
SK Hynix produces DRAM and NAND memory chips – demand will only grow as AI functionality increases and requires more memory to function. SK Hynix is also the industry leader for high bandwidth memory, with a dominant market share.

AI on the ASX

While Australia is not necessarily known for a large tech industry, that’s not to say you can’t find AI opportunities on the ASX.

Mclean points to Goodman Group (ASX: GMG) and Pro Medicus (ASX: PME) as potential AI plays.

“[Goodman Group] have quietly amassed a huge development pipeline of data centres. It now has over 3GW of data centre capacity in key tier 1 markets,” he says.

Imaging software leader Pro Medicus is currently going through approvals for an AI algorithm to interpret diagnostic images – “as approvals are granted, Pro Medicus’ solution could become the platform for third-party AI companies.”

A final word of warning

“Do your fundamental research. AI companies are not some mythical beast that can evade the rules of good investing,” says McLean.

He cautions investors to think about which companies will still exist in five years and which are just flash in the pan – think in the early days of the internet.

For Fang, it comes back to fundamentals – stick to the basics like ROIC, ROE, and free cash flow and when you factor AI, consider whether a company has multiple avenues to deploy and benefit from it.

At the end of the day, AI is only nascent – it’s going to transform the world so look for under-appreciated AI potential in good quality businesses as your starting point.