Can transformative businesses such as AI reward most investors over time?

MANY people believe that artificial intelligence (AI) will be the most transformative technology in the world today. It is said that AI will transform various industries from finance to healthcare.

Hence, investors are rushing to buy AI-related stocks for capital appreciation over time as the demand for AI technology is believed to be at the beginning of a long-term uptrend.

Can transformative businesses such as AI reward their investors over time?

Seeking an answer, I turned to the article, Mr Buffett on the Stock Market, published in Fortune magazine on Nov 23, 1999. In the article, Buffett looked at two industries that transformed America in the last century: automobiles and aviation.

First, automobiles. There were plenty of car and truck-makers in the early days. In the end, only three US companies survived. Buffett then opined that investors could have grasped the importance of automobiles but still found it hard to pick the real winners.

Second, airplanes. There were about 300 aircraft manufacturers in the 1919-39 period but only a few have survived till today. In the case of airlines, there were 129 airlines that filed for bankruptcy in the past 20 years (as of 1999). The airline companies made no money since the dawn of aviation till 1992.

Lesson for investors

Here is Buffett’s lesson for investors from these transformative businesses: “I won’t dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to US investors: the manufacture of radios and televisions, for example.

“But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

He notes how few people got rich from these two transforming industries, auto and aviation. As for the Internet?

In hindsight, the Internet bubble was probably the largest stock market bubble in history. Trillions of dollars were wiped out when the bubble burst in 2000. Many high-flying stocks in the 1990s ceased to exist or continued to underperform the market after the bubble burst.

In the 1990s, there was widespread adoption of personal computers (PC) as people sought to access the Internet. Microsoft and Intel were the clear-cut winners as most PCs inevitably used the Windows operating system that runs on Intel chips.

If investors had bought Microsoft and Intel in the first quarter of 2000 and held the stocks till Q1 2024, their annualised returns would be 11.2 per cent and 0.6 per cent respectively, according to Research Affiliates, an investment firm. This example shows just how hard it is to pick long-term winners.

Another example is Cisco, which dominated the Internet routers business. It was once the world’s most valuable company during the Internet boom.

In May 2000, Fortune magazine ran a cover story on Cisco titled, “Two questions about Cisco”. If you were stranded on a deserted island and could own only one stock, the writers asked,what would it be? The writers concluded : “No matter how you cut it, you’ve got to own Cisco.”

Cisco’s stock price peaked at about US$80 in 2000. Though its sales and earnings grew thereafter, its current stock price (as at Nov 6, 2024) was US$57, some 25 years later. The crux of the issue is that investors were apparently paying too much for the stock as it was traded at more than 100 times earnings. This brings us to the issue of stock valuation.

In the 1970s, the prices of a group of large growth stocks skyrocketed. These great companies were called the “Nifty Fifty” and they included IBM, Coca-Cola, and Xerox. The average price-to-earnings (P/E) ratio of these stocks was about 42 times at their 1972 peak. However, these stocks came tumbling down in the 1973-1974 bear market.

As Charlie Munger, Warren Buffett’s right-hand man, put it in a speech in 1994 : “Since it is obvious that investing in great companies works, it gets horribly overdone from time to time. In the ‘Nifty-Fifty’ days, everybody could tell which companies were the great ones. So they got up to 50, 60 and 70 times earnings. And just as IBM fell off the wave, other companies did, too. Thus, a large investment disaster resulted from too high prices. And you have got to be aware of that danger.”

The hard truth

In the 1990s, it was widely believed that technology, media, or telecom companies would fundamentally change how we communicate or access information. Hence, it did not matter what price you paid for these stocks.

Investors in the 1990s were extremely bullish as they paid more than 100 times P/E for large cap stocks. At the market peak in March 2000, six stocks out of the 20 largest US stocks in terms of market value spotted P/E ratios of more than 100 times. These stocks included Cisco, AOL Time Warner, Oracle, Nortel, Sun Microsystems, and EMC Corp. Subsequently, the prices of these stocks declined dramatically during the 2000-2002 bear market.

The hard truth is that it is generally not advisable to buy stocks traded at the huge P/E premium to the general market. Valuation did really matter in the long term as investors found out in the 1970s or 2000s. By the way, the P/E ratio for the general market was about 17 times over the past 25 years.

Currently, investors are very bullish on AI stocks, particularly the “Magnificent Seven” – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. Investors were paying about 30-70x P/E for these seven stocks around June 2024. The average P/E ratio is about 45 times. Are investors overpaying for these stocks? Things will become dicey if the companies could not deliver on their promise or meet investors’ expectations.

It is also unclear if investors could actually pick the long-term winners in the AI industry. A highly lucrative business tends to attract a lot of competitors. Is the competitive advantage of current high-flying firms durable?

Companies have poured billions of dollars into AI. It was reported that Alphabet, Amazon, Meta, and Microsoft have together spent about US$600 billion on AI since 2020. So far, none of these companies has made money on AI yet. Importantly, will the billions of dollars spent on AI eventually pay off – and when?

In short, the previous episodes of transformative businesses tell us that investors tend to overpay for those stocks. We also learn that it is extremely hard to pick the long-term winners.

Last but not least, billions or even trillions of dollars of capital investments tend to get wiped out during the bust, though the capital investments did yield some long-term benefits to society. Most of the businesses involved were not so lucky though. Could AI businesses reward its investors over time? Time will tell.

The writer is a private investor. He was previously a researcher at an international business school in Europe and an Asia-Pacific director at multinational corporations.