How to realise AI’s investment potential – without getting caught in the hype

UNLESS you have been living off-grid in recent years, artificial intelligence (AI) will need little introduction. While AI itself is nothing new, the increasing availability of generative AI and large language models (LLMs) to the public, and their first steps into commercialisation over the last year have thrown the sector even further into the spotlight.

The long-term, game-changing potential of AI makes it a clear fit for thematic investing. After all, the latest tools are multi-purpose and easy to use, meaning they could transform a wide variety of activities and industries over the coming decades. However, investing in the sector is not without challenges.

AI adoption has progressed at unprecedented speed, helping to raise the level of hype around AI companies to fever pitch. Furthermore, size matters in AI – larger models display disproportionally greater performance – which means there are a lot of dollars pouring into what is a computing arms race. This is despite – or perhaps because of – the fact that the sector is still at an early stage.

The fact is, AI adoption may ultimately progress in unexpected ways that will be hard to predict.

AI winners and overlooked beneficiaries

The hype around AI has caused large differences in the valuations of companies perceived as beneficiaries from AI and those perceived as being left behind by the advance in technology. Lofty valuations have left investors questioning how to invest without overpaying for hyped stocks.

To tackle this and strike this delicate balance, it is important to explore not just companies that the market believes will be “AI winners”, but also look into those that have so far been overlooked by other investors, but have the potential to benefit from AI.

The first question you might ask is who are these “AI winners”? One simple way to consider this is to look at firms that stand to make immediate gains from AI over those whose potential profits are further into the future. Many AI enablers, including software and hardware makers, are already turning the AI rush into bottom-line performance.

These could be companies that own critical components for the early AI investment cycle, or who already have direct AI offerings as well as infrastructure to enable the building of AI tools.

However, when it comes to “AI winners”, it is still important to take a cautious approach. While many such companies have high valuations, it is hard to tell with certainty that they would be able to convert their promise into profit in the near term. The path of AI adoption from here is difficult to accurately forecast, so you could be paying a high premium for companies not yet generating revenues from AI, in what is a highly uncertain market.

What is often overlooked by the market are the underappreciated beneficiaries of AI. These are companies that could benefit significantly if AI becomes mainstream, but whose potential is not yet reflected in their stock prices.

Passive indices, for example, are typically dominated by those already widely believed to benefit from AI. But being able to identify long-term AI beneficiaries before their valuations become stretched is an untapped area with huge potential.

Looking ahead

The fact is, AI is a good fit for thematic investing because it represents a structural shift that has longevity. The difficulty comes in how successfully you can strike a balance between near-term revenues and underappreciated potential. The objective is to generate long-term returns, while not overpaying for hyped companies that may or may not deliver.

In such cases, bottom-up stock selection is particularly important. It might be clear which sector a company sits in, but the sort of technology the current management plans to develop or adopt in the next decade may be less obvious.

The level of a company’s exposure to a theme is also a matter of judgment, particularly since the exposure will vary over time, depending on business priorities. This sort of knowledge often requires specialist research and experience to understand each company’s unique drivers in the context of external shocks and a constant baseline of change.

AI is a compelling thematic investment opportunity, but investing in the sector is not as straightforward or as easy as one might think. Forward-looking analysis using bottom-up fundamental research to invest in both market leaders and underappreciated beneficiaries is one way that investors can realise the potential of a multi-decade theme such as AI.

The writer is portfolio manager, Fidelity International