Morningstar - Q2 2024 - 34

Spotlight: Artificial Intelligence
Are There Any Undervalued
Opportunities Left in AI?
Investors should look beyond big names
and focus on moats.
David Sekera, Kenneth Lamont, and Grady Burkett
INVEST
Few themes have caught the market's attention
as much as artificial intelligence. AI
stampeded into the market consciousness in
November 2022 when OpenAI launched
ChatGPT. This large language model quickly
captured the imagination of users who
began to analyze how AI could be a catalyst
to boost productivity, drive revenue, and
enhance profitability.
In this modern-day version of the gold rush, the
first companies to benefit from the voracious
demand to build out AI capabilities were those
making the " picks and shovels " -which today are
the graphics processing units used to train AI
and the cloud resources and data centers
to house the vast amount of data that AI requires.
The stocks of the obvious immediate beneficiaries
of the growth in AI have surged and,
according to our valuations, are generally fully
valued to overvalued at this point. Looking
forward, investors will need to determine who will
benefit in the long term and be able to meld
AI into their business models to bolster growth
and increase productivity.
We have three pieces of advice for turning AI
ideas into actions for 2024:
1 Focus on second-derivative plays. Rather than the
big AI players, we see potential opportunities
in the next rung of AI adopters. This includes those
that can strengthen their products using AI,
without the valuation risk.
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Morningstar Q2 2024
2 Beware of ultrahigh valuations. Prices have run
up very quickly, so there's an expectation of
strong growth already priced in. As competition
rises, we could see disappointments.
3 Focus on moats. Companies that have the
greatest competitive advantages are likely to thrive.
They will also be less susceptible to obsolescence.
Taking Stock of the AI Landscape
Artificial intelligence is expected to change the
way business is conducted, especially with
the progression of generative AI. The pace of
change is remarkable, and investors are naturally
eager to understand the winners and losers.
While we'd warn them not to let hype dominate
their investment decisions, we are seeing a
tremendous shift in the makeup of equity markets
that's worthy of note for all investor types.
By now, many investors have tested AI platforms
and have seen the power of AI firsthand.
We expect 2024 to be a year of phenomenal
change in this space, as the race to build market
share has begun. We expect rife competition
within the buildout of artificial intelligence
hardware, platforms, and usage. Practically every
company in the world is seeking to understand
how it can use this technology to increase revenue
and profit margins.
We see two main ways that AI can add to
company performance. The first is automation,
such as creating efficiencies in the back office
and improving processes. Anecdotally, back-office
efficiency is the primary motive for most large
companies at this stage. However, we expect
generative AI and predictive analytics to ultimately
play a greater role across practically every
business function and industry. The second
is product and service enhancement, potentially
creating new revenue growth opportunities
and improving the economic value for customers.
We expect rapid growth for both the hardware
and software needed to develop, train, and use
AI ( EXHIBIT 1 ). With only a small dose of
imagination, we can quickly identify use cases for
over 90% of the workforce in developed and
many emerging markets.
The list of major AI players includes many
familiar names to investors ( EXHIBIT 2 ). However,
valuations have increased significantly in
anticipation of success. While they may have
a first-mover advantage, they are still subject
to risk, and it will be even more difficult than usual
to forecast how artificial intelligence will
develop over the medium to long term. As such,
most of these stocks have either High or Very
High Morningstar Uncertainty Ratings, and
their stock prices could be highly volatile in the
years to come.
Risks to Be Aware of in AI Stocks
Regarding investment risks, AI does bring some
new challenges to the table.
Valuation
Even fast-growing businesses can be poor
investments if investors overpay for their stock.
It's also important to keep in mind that the largest
portion of a growth company's value is
derived from cash flows generated many years in
the future. Companies that develop durable
competitive advantages are more likely to maintain
long-term free cash flow growth and could
warrant higher valuations. However, this is a
very expensive race with significant uncertainty
about the future winners and losers. A lot
must go right for the primary AI stocks to continue
to deliver, but the risk/reward trade-off can
deteriorate if investors overpay.
Regulation and Safety
Let's start with the risk of artificial intelligence
itself. The technological capabilities are under
immense scrutiny from both users and
governmental regulators. While it is acknowledged
Morningstar - Q2 2024

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