The adoption of artificial intelligence (AI) has driven huge gains in the US stock market over the past 18 months led by the greatest beneficiary of all, semiconductor company, Nvidia. The AI theme is likely to be an enduring one with winners including the biggest technology companies, as they are able to invest massive amounts of cash in this emerging technology.
Yet as AI takes the world by storm, policymakers face a significant challenge in regulating AI as innovations quickly expand and citizens across the globe demand action to ensure the rollout of AI balances the enormous opportunities touted by true believers with the real and perceived risks emphasized by the vast majority of people.
Despite these risks, big technology companies have turbocharged their efforts to develop AI models and applications. In many cases they appear more interested in speed than safety, following the adage of "move fast and break things." This is not surprising given the winner-takes-most nature of digital tech and AI. However, the public wants increased transparency and is demanding thoughtful regulation. However, regulators need to "skate to where the puck is going" and that is not at all clear at this point.
There are lots of ways to mess up regulating a new technology
The history of regulation suggests one major risk is a rush to act, without considering the full benefits of AI technology. As often occurs, regulators may inflict a lot of harm in an attempt to do a little good.
One key risk is strangling innovation, as frequently transpires, particularly in Europe. Another risk is regulatory capture, which seems especially likely in the US given the high stakes and dearth of AI expertise in government. A third risk is state dominance, as is occurring in China. There are lots of ways to mess up regulating a new technology.
In terms of encouraging innovation, the US is usually much more effective than Europe and other economies. "American exceptionalism" largely reflects its light regulatory touch and unrivalled venture capital ecosystem. And this helps explain why most top AI professionals chose to work in the US, even among those born abroad. It also clarifies why America captures the lion’s share of private sector investment in AI.
When it comes to regulation, history shows us that mistakes are likely to be made, and they will have important implications for the pace of innovation, the structure of the tech industry and the cash flow accrued by investors. While there are also risks to insufficient regulation, the track record with digital tech makes it clear that premature implementation of a rigid and complex regulatory framework is likely to impose excessive costs but do little to protect society.
Some commentators quip that "AI will be the first industry to be regulated before it becomes an industry." With new technologies, it usually takes ten to twenty years before a regulatory framework is put it place. This reflects the fact that nobody possesses a crystal ball, so we do not know which startups will become the next titans, and which current superstars will fall. This level of uncertainty means governments need to proceed cautiously before introducing restrictive laws regulating new technologies and halting progress.
Moreover, we believe AI represents the fourth wave of digital technology following the PC, internet, and mobile phones. Overregulating this emerging technology would harm the pace of technological development, damaging innovation, productivity, economic growth, and national security.
Winners from the AI movement
Digital tech always features winner-takes-most dynamics and AI will not prove an exception. This means aspiring titans need to move fast and invest massively. There is room for only a small number of winners in each segment and those companies will reap the vast bulk of free cash flow and profits going forward.
One computer chip design company illustrates this dynamic. Nvidia has led the AI gains to become almost as large as Microsoft and Apple, momentarily becoming the largest company in the world in mid-June. But Nvidia’s price now assumes that it will grow earnings by 20% a year for the next 18 years. Other companies have done that - Apple did it, Microsoft did it. But they did it when they were much smaller companies. This makes us sceptical regarding future returns for Nvidia's shareholders. We are similarly sceptical about Tesla.
Our preference is to seek companies with a return on invested capital (ROIC) well above their weighted average cost of capital (WACC). We also look for high and sustainable operating margins and a solid track record of generating free cash flow (FCF). Regarding valuations, we want to be confident that the earnings growth already incorporated in the share price seems reasonable and attainable. From this perspective, AI leaders such as Microsoft, Google and Meta are interesting.
Other potentially interesting companies include Taiwan Semiconductor Manufacturing Company (TSMC), the Taiwanese contract manufacturing company. It fabricates the vast majority of leading-edge chips, including those designed by Nvidia.
Semiconductor equipment company, ASML is also interesting. Dutch-based ASML has overtaken the French luxury giant LVMH as Europe’s second largest company, second only to drug maker Novo Nordisk. ASML has for a time been Europe's largest technology company, making the lithography machines that are critical to chip manufacturing. It possesses a near monopoly in this segment, a result of almost four decades of intense research and development.
Education and healthcare are among the sectors to benefit from AI
Healthcare is one industry where we see AI having tremendous impact. Healthcare is about 20% of U.S. gross domestic product (GDP), and a similar percentage of employment. There are many areas where AI can be used in the sector, including transcribing doctors' notes, diagnosis and assisting radiologists, as well as drug discovery and the invention of new antibiotics. The challenge with the healthcare sector though is that it's highly regulated and institutionalised, which sometimes makes it quite resistant to change.
Another sector likely to benefit is education. A company called Khan Academy, run by Sal Khan, has an AI application called Khanmigo, and it's currently being rolled out in a small number of schools. This is a terrific development, as it enhances the education process and gives every student an AI tutor focused on their needs, interests, and pace of learning. AI will also change the role of teachers, who will spend less time lecturing and grading papers and more time supervising, monitoring, helping students when they get stuck, and overall acting like a conductor.
AI will also have dramatic impact on the entertainment industry, including music and video generation. OpenAI's Sora application, for example, focuses on creating animated content, in some cases reducing the cost of producing animation by 99%. This will create challenges for places like Disney and Netflix, but ultimately, we're going to be able to enjoy even more quality content than we have today.
Ted Sarandos, the co-CEO of Netflix, argues AI is just another tool to help them tell stories that people love. We agree and believe the best way to think about AI is that it augments our abilities. This is true for healthcare professionals, educators, creative workers, and people in the finance sector. Whether you are a financial analyst, a portfolio manager or an advisor, AI is a tool that complements your abilities, enabling professionals to be even more effective and productive. Overall, AI is likely to be a net positive for many roles, as it augments what professionals do on a day-to-day basis.
To conclude, AI is likely to be the key investment theme for at least the next decade. This presents many opportunities for investors, as well as a number of challenges. One of these is that there's usually room for only a small number of winners in each segment and those companies get the vast bulk of free cash flow and profits going forward. This means increased market concentration, which is an integral feature of digital tech and AI. A second challenge is that a killer app might be years away which suggests significant market volatility going forward.
Dr Kevin Hebner is Managing Director, Global Investment Strategist with Epoch Investment Partners, a fund manager partner of GSFM, a Firstlinks sponsor. The information included in this article is provided for informational purposes only.
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