CIO believes that investors looking for exposure to AI should seek broad exposure across the value chain. (UBS)

The Magnificent Seven—the largest, mostly AI-related stocks in the S&P 500—have rallied by 108% year-to-date and the broader tech-heavy Nasdaq index has gained 43%.

After such a strong run, investors should be prepared for potential short-term volatility or drawdowns. As with other technology booms, an initial surge in demand can often be followed by a digestion period for consumers and businesses. But the long-term growth potential is large, in our view, and any such periods could present attractive entry points to increase exposure to these leaders from disruption:

Generative AI is a disruptive and potentially transformative technology. History shows that the advent of new technologies can create value across a range of sectors in an innovation value chain. Generative AI is the latest example of a breakthrough technology powered by infrastructure and inputs, creating new hardware running on platforms of operators and enablers, and benefiting the economy at large.

We expect global AI demand to increase from USD 28 billion in 2022 to USD 300 billion in 2027, based on Bloomberg Intelligence data—a compound annual growth rate of 61%. In that time, we think the infrastructure segment will grow by 38% and the applications and models segment by 139%. We see upside risk to our estimates given improving visibility on infrastructure spending and broadening AI demand for applications.

The big are likely to get bigger. An unusual feature of generative AI is that, right from the onset of the new technology, many of the same companies are already operating in multiple stages of the value chain––from cloud to the ownership of large language models (LLMs), to the development of end-user applications. With that in mind, it is perhaps understandable why the market capitalization of the Magnificent 7 has more than doubled so far in 2023. With the significant resources needed to build and benefit from complex AI models, we expect the large players to grow larger still.

Near term, tech should also benefit from its quality characteristics. In 2024, we expect slowing economic growth and believe companies with strong returns on invested capital (ROIC), resilient operating margins, and low debt on their balance sheets will be best positioned. Such quality stocks have historically outperformed during periods of economic slowdown or contraction.

This quality tilt speaks in favor of US technology companies. Technology offers the highest ROIC of the 11 US equity sectors: around 20% over the last 12 months (compared with around 3–4% for utilities or real estate). Tech sector balance sheets are also the strongest, with an average net-debt-to-EBITDA ratio of just 0.5x. With business models that combine subscription-based revenue streams with a presence in high-growth segments including artificial intelligence, we think tech companies look poised to deliver healthy earnings growth next year.

Stocks have already rallied hard in anticipation of higher AI demand, yet we think companies across the AI value chain—from cloud to semis, software, and internet—have further to run, both in 2024 and over the longer term. We believe that investors looking for exposure to AI should seek broad exposure across the value chain.

Main contributors – Solita Marcelli, Mark Haefele, Vincent Heaney, Sundeep Gantori, Jennifer Stahmer

Read the original report : AI: More to come in 2024?, 20 December 2023.