Key sectors to watch in the second half: AI and Reits

THE first half of 2024 flew by in a flash. The constantly changing economic landscape, marked by news of wars and US politics, made it challenging for investors to navigate the stock market and select sound investments.

One effective way to identify investment opportunities is to observe trends and their impacts on various industries. These trends should ideally be long-lasting, providing a strong boost to the businesses you’re researching.

More importantly, you should be seeking companies which are directly or indirectly benefiting from these trends.

With these factors in mind, here are two intriguing sectors to watch for the rest of 2024.

Artificial intelligence

Artificial intelligence (AI) has been this year’s buzzword, and Nvidia’s impressive share price performance has astounded investors. Shares of the graphics processing unit (GPU) manufacturer have gained 137 per cent year to date, building on a remarkable 246 per cent rally in 2023.

However, investors may be wary of the company’s high valuation. Currently, Nvidia trades at a trailing 12-month price-to-earnings (PE) ratio of almost 67 times. But the GPU maker is not the only company benefiting from the AI boom.

There are companies such as Alphabet and Meta Platforms which are making moves in the AI arena and offering more attractive valuations. For instance, Alphabet’s Google search engine has integrated AI into its popular products such as Gmail and Google Docs. The company also has a robust cloud computing division that provides generative AI solutions to its cloud customers.

Meanwhile, Meta Platforms recently unveiled its latest Llama 3 AI model. This mostly free software can converse in eight languages, write high-quality computer code, and solve more complex math problems than its predecessor. What’s more, Meta reported strong earnings for the first quarter of 2024, with revenue up 27 per cent year on year to US$36.5 billion. Net profit more than doubled to US$12.4 billion.

Compared to Nvidia, Alphabet trades at just 25 times its trailing 12-month earnings, while Meta Platforms has a trailing 12-month PE ratio of 26.5 times, slightly higher than Alphabet.

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If you prefer to avoid risky growth stocks, stocks in the semiconductor industry offer a solid alternative. The AI boom will take time to benefit the middle and back-end semiconductor players, creating opportunities for patient investors willing to wait for the industry’s cyclical upturn.

Industry monitor World Semiconductor Trade Statistics forecasts that the global semiconductor market will grow by 16 per cent year on year to US$611 billion, followed by a 12.5 per cent increase in 2025 to reach US$687 billion.

One of the beneficiaries is Singapore-listed Micro-Mechanics , which supplies parts and consumables for the semiconductor industry. It reported a 12.8 per cent year-on-year increase in net profit for its most recent quarter. CEO Chris Borch is cautiously optimistic that an upturn is just around the corner and is upgrading the group’s factories to “five-star” facilities to capitalise on the industry gains.

Another local semiconductor player, UMS Holdings, a provider of equipment manufacturing and engineering services for semiconductor original equipment manufacturers, saw a 44 per cent year-on-year drop in net profit for the first quarter of 2024, to S$9.8 million.

Despite the weak results, CEO Andy Luong expressed optimism, with the group recently acquiring new leasehold industrial land in Malaysia to prepare for future growth. In a show of confidence, an interim dividend of S$0.012 per share was paid out, 20 per cent higher than the previous year.

Real estate investment trusts

Apart from the semiconductor sector, real estate investment trusts (Reits) are another area to watch. Since March 2022, Reits have been hit hard by the US Federal Reserve’s series of interest rate hikes to combat runaway US inflation, which peaked at 9.1 per cent in June 2022. The federal funds rate jumped from zero to a range of 5.25 to 5.5 per cent in just 16 months, where it remains today.

Amid the rate hikes, Reits struggled with soaring interest costs as they refinanced loans at higher rates, squeezing distributable income and leading to lower distributions. For instance, the unit price of the Lion-Phillip S-Reit ETF, an exchange-traded fund which gives exposure to 25 Singapore Reits (S-Reits), dropped by 11.7 per cent from March 2022 to the end of July 2023.

However, there may be a glimmer of hope for the sector later this year. The latest US inflation reading was 3 per cent for June, the lowest level in three years. Meanwhile, the US labour market is showing signs of weakening, with the unemployment rate rising to a 2.5-year high of 4.1 per cent.

These factors increase the likelihood that the US central bank may start cutting interest rates as early as September this year. If this happens, it would relieve the pressure on S-Reits when refinancing their loans.

Many S-Reits still report lower distributions due to the sharp rise in interest rates. For example, Mapletree Logistics Trust ’s borrowing costs increased by 9.4 per cent year on year, limiting its ability to pay out higher distributions.

OUE Reit faced similar issues. The commercial and hospitality Reit experienced an 18.5 per cent year-on-year rise in finance costs for H1 2024. Combined with a higher retention sum for working capital, distribution per unit dropped by 11.4 per cent year on year to S$0.0093.

Still, with lower rates on the horizon, Reits could see this headwind diminish in H2 2024. As rates decline, it will be disadvantageous for a Reit to have too much fixed-rate debt, as this may limit its ability to refinance at lower rates. Additionally, a strong sponsor can help the Reit lower its overall borrowing costs.

The sector may be undergoing a tough period now, but S-Reits with robust portfolios and strong demand should weather this storm. The current depressed environment also presents attractive opportunities to accumulate shares of well-managed Reits at a discount.

Get smart: An eye on the business

While these two sectors may offer promising opportunities in the near term, investors should always focus on the long-term competitive advantages of businesses in these sectors. Valuations should be analysed alongside business prospects rather than in isolation.

It’s also crucial to consider the risks, as projections and economic estimates may not always be accurate. If you’re unsure, start with a small position and gradually add to it as you become more familiar with the sector and business.

I wish you success in your investment portfolio in 2024 and beyond.

The writer owns shares of Alphabet, Meta Platforms and Micro-Mechanics. He is portfolio manager of The Smart Investor, a website that aims to help people invest wisely by providing investor education, stock commentary and market coverage.