Big Tech’s $62 Billion AI Investment Creates New ‘Pick-and-Shovel’ Opportunities

In the two years since the launch of ChatGPT, artificial intelligence has enthralled investors more than any technological innovation in the past two decades. Leading tech companies are pouring tens of billions of dollars into enhancing the computational power needed to design and run AI systems each quarter.

For its most passionate advocates, the potential outcomes are astounding: AI is poised to replace many jobs, assist researchers in finding life-saving treatments, help businesses penetrate new markets, and create substantial efficiencies that could elevate corporate profits for years to come. As a result, stocks associated with AI have played a major role in the bull market that began in October 2022.

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Despite its enormous potential, AI has yet to yield significant revenue due to its costs. A recent Gallup survey found that just 4% of U.S. workers utilize AI on a daily basis, while over two-thirds reported they never use it. Daron Acemoglu, a Nobel Prize-winning economist from MIT, contends that the typical expectations surrounding AI developments are overly optimistic. “The models we have today are quite impressive, but they remain largely impractical on a wider scale,” he explains.

Some investors find themselves harking back to the 1990s, a time of similar enthusiasm surrounding the emerging internet. That technological transition took longer than anyone anticipated, resulting in a stark divergence between stock valuations and actual fundamentals, ultimately leading to a significant market collapse. Presently, many Big Tech stocks are again trading at earnings valuations that surpass historical averages.

Currently, whether they realize it or not, most investors are essentially wagering on AI.

If you own an S&P 500 index fund, approximately one-third of your investment is tied to eight firms, including Nvidia, Microsoft, and Apple, all banking on the future promise of AI. This doesn’t even account for other sectors, like utilities, which also benefit from the energy demands of AI data centers.

Read/listen: We are being swept along inexorably by the AI boom

For both supporters and doubters of AI, it’s crucial to assess the associated risks and opportunities. Begin by distinguishing between companies that develop AI solutions, such as Microsoft Corp and Alphabet Inc, and those that provide the required infrastructure—including chips, servers, and energy—that facilitate computing.

The leading tech firms are highly lucrative, accounting for a significant portion of AI expenditures. In Q3 2024, together Alphabet, Amazon.com, Apple, Meta Platforms, and Microsoft invested $62 billion in capital expenditures, a record figure reflecting an increase of more than 50% from the previous year. Notably, for the first time since 2018, this group spent more on capex than on stock buybacks—$5 billion more, to be specific. These tech giants clearly have the financial strength to sustain such spending patterns, having generated $76 billion in free cash flow, with investors generally endorsing Big Tech’s capital investments due to the sector’s historical performance.

Dave Mazza, CEO of Roundhill Financial Inc, a New York-based investment firm, posits that AI will eventually generate significant revenue, but he cautions that investors may run out of patience. “If companies announce commitments to spending without clarity on the timeline for returns, investors are likely to exit,” he warns. “At some point, reality will set in, and time is of the essence.”

Read: Megacap tech stocks have gotten too big for Nasdaq 100 again

Arvind Narayanan, co-author of AI Snake Oil: What Artificial Intelligence Can Do, What It Can’t, and How to Tell the Difference, asserts that significant returns from AI will take more than just a year or two to materialize. “Integrating new technology requires adjustments to workflows, organizational structures, and legal frameworks,” explains Narayanan, an associate professor of computer science at Princeton University. “These changes don’t occur at the speed of technological advancement. Therefore, we should expect it may take ten years or more for companies to fully gain the benefits of even today’s generative AI.”

Currently, the most visible AI-driven revenue for tech giants arises from their cloud platforms, like Amazon Web Services and Google Cloud. However, Microsoft—an early adopter of AI through its partnership with OpenAI, the creator of ChatGPT—faces its own challenges. By the end of November, Microsoft’s shares had underperformed the S&P 500 for four straight months. In October, the company experienced its largest stock decline in two years due to a disappointing revenue growth forecast for its Azure cloud service. Despite this, Microsoft is set to invest $62 billion in capital expenditures this fiscal year, more than double its spending two years ago. Alphabet, Amazon, and Meta also announced plans for increased investments.

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This commitment has fostered confidence among those following a well-known investment strategy focused on AI: the pick-and-shovel approach, reminiscent of the suppliers who profited during the California gold rush of the 19th century. Nvidia Corp exemplifies this trend, dominating the market for chips designed specifically to handle AI computations. Its shares have surged over 700% since ChatGPT’s launch in November 2022, making it one of the world’s most valuable companies, boasting a market capitalization of $3.4 trillion by the end of November, vying for the top position alongside Apple Inc.

Read: Microsoft unveils zero-water data centers to reduce AI climate impact

Even the traditionally stable stocks of utility companies are witnessing strong performance. Vistra Corp and Constellation Energy Corp are among the top performers in the S&P 500 in 2024, putting utility stocks on track for their best year since 2019.

With major tech firms promising ongoing investment, even skeptics like Jim Covello see no reason to abandon the pick-and-shovel strategy while the capital continues to flow. Covello, head of equity research at Goldman Sachs Group Inc, claims that AI is unlikely to meet many of the lofty expectations its proponents espouse. “Most major technological shifts in history, especially the transformative ones, have involved replacing very expensive solutions with cheaper alternatives,” he remarked in July. “So far, AI—and its associated high costs—stands in stark contrast.” He believes that when this realization spreads, tech giants will reconsider their expansive spending, putting pressure on infrastructure stocks.

This scenario could pose a challenge for Big Tech, impacting their growth outlook. However, it’s unlikely to significantly detract from their long-term appeal, as growth in their core businesses is expected to remain steady.

Consider Meta Platforms in 2022, when the parent company of Facebook made substantial investments in developing the metaverse. When revenue slowed, the stock took a nosedive. Yet, Meta rebounded, trading at record highs following multiple acknowledgments from CEO Mark Zuckerberg and a strategic shift in focus.

Read: A very ChatGPT Christmas

Identifying the long-term victors in this new landscape may prove challenging, according to Michael O’Rourke, chief market strategist at Jonestrading in Chicago. In 2000, hardware manufacturers like Cisco Systems Inc and Sun Microsystems—the pick-and-shovel providers of the dot-com boom—were among that era’s top performers. However, it was companies like Amazon and Google that ultimately rose to prominence, constructing significant businesses around the potential of technology.

“Typically, others refine these concepts to dominate the market,” O’Rourke explains. “We are still in the early stages of grasping how the landscape will shift in the coming years. I caution that it’s too soon to make a definitive judgment; suggesting otherwise might lead potential investors to take unnecessary risks. The late ‘90s was an early phase of the internet era, and it was not the best time to invest.”

© 2024 Bloomberg

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