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Posté par Nicholas Mersch en juil. 18ème, 2024

Justified Concentration

The year of artificial intelligence rages on, and the market has decided that the beneficiaries of AI will be the following:

  1. Semiconductors
  2. Infrastructure builders
  3. Cloud providers (mega-cap)
  4. No one else.

Capital has crowded around the incumbents as it seems we’re inundated daily with market-cap concentration charts showing crowding around the majors. These charts are usually accompanied by some fantastical saying like, “Market-cap concentration not seen since the previous tech bubble!”

While market concentration is currently high, I would encourage every investor to zoom out and ask if this is justified. Michael Mauboussin penned an excellent piece in which he outlines:

“The most basic way to think about stock market concentration is to consider the distribution of value creation. Individual companies commonly see their value creation prospects improve and worsen during their lifetimes. Stock prices tend to reflect expectations about future value creation. Stock market concentration may be justified if the market capitalizations mirror the value creation prospects. Economic profit is one way to measure the magnitude of value creation.

Economic profit equals return on invested capital (ROIC) minus the weighted average cost of capital (WACC) times invested capital.

Economic Profit = (ROIC – WACC) × Invested Capital

Aggregate ROIC for large and small cap stocks 1990-2023

Tech Stock Fundamentals

When we look at the fundamentals within the S&P 500, tech stocks are doing all the heavy lifting on every metric. They are growing faster than the rest and have profitability better than the rest. Following Mauboussin’s reasoning above for economic profit, we can conclude that fundamental results justify rising concentration:

“From 2014 to 2023, the top 10 stocks were 19 percent of the market capitalization, on average, while the companies made up 47 percent of the total economic profit. In 2023, the top 10 equities were 27 percent of the market capitalization, and the firms contributed 69 percent to the total economic profit.”

Economic profit of top 10 by market cap 2014-2023

To me, this concentration seems reasonable and is completely justified; value should be ascribed to those companies that are the most productive in the marketplace.

AI's Role in Revenue and Profitability

The next and most critical question to ask is: How sustainable and defensible is earnings growth?

I’ll start with the conclusion. I strongly believe that the incumbents will continue to dominate fundamental revenue growth and profitability, and artificial intelligence will further accelerate this.

Unless you’ve been hiding under a rock, you are well aware that we are in the next era of technological change: AI. Historically, when disruptive innovation occurs, startups are frequently instead of the incumbents that stand to benefit. The logic goes – incumbents are big and slow-moving when it comes to major decisions to adapt to change. Being more nimble, startups can focus narrowly on a specific problem by applying new technology and expanding their reach as they find new markets to capture.

This time it’s different. The large tech companies, mainly the cloud providers (Amazon’s AWS, Microsoft’s Azure, and Google GCP), have gated access to the two primary resources needed to unleash the power of AI: data and compute.

Cloud providers have spent the better part of the last couple of decades building massive data repositories. AWS, founded in 2006, controls over 30% of the cloud market, which is projected to reach 200 Zettabytes by 2025.1 To put this into context, It is estimated that approximately 500 hours of video are uploaded to YouTube every minute. 200 ZB would be equivalent to the data stored by YouTube over more than 760,000 years at current upload rates.

That’s a lot of data, and it will only expand with AI.

CapEx and AI Infrastructure

Compute is expensive. Very expensive. Current methods of AI require extremely intensive amounts of compute. One OpenAI search needs 10x the power required for a Google search. Mega-caps are the only entities that can fund this endeavour. After extracting large amounts of free cash flow over the last few decades, mega-caps have built sufficient war chests for this next CapEx megacycle.

Nothing else competes.

For instance, here in Canada, we have pledged $2.4B to increase AI adoption. By some estimates, AI-related CapEx alone from four hyperscalers was $125B in 2023 and is set to grow at multiples of that over the coming years.

Additionally, the CHIPS Act pledged $39B to build out domestic semiconductor manufacturing in the US – dwarfed by the more than $300B of private investment that companies have pledged to the US semiconductor manufacturing industry since 2022.2 While government subsidies can help move certain initiatives along, free-market capitalism controls economies over the longer term.

The concepts of data aggregation and heavy CapEx further entrench the mega-cap moats, and these companies will continue their dominance.

Investment Implications

So – what does this mean for the investing universe? Should you just pile into the mega-caps and call it a day? Not necessarily.

While the mega-cap cloud companies (Microsoft, Amazon, and Google) will capture a lot of future revenue opportunities for AI, they are still in spending mode right now. They’re spending heavily on semiconductors, data centre infrastructure, and energy.

We’re still in the infrastructure stage of the buildout cycle.

Two things will change my mind:

  • The first is a slowdown in mega-cap CapEx. Every buildout phase usually expands faster than expected and contracts faster than expected. For now, there are still no signs of contracting. Still, if there is any retreat in planned CapEx spend amongst the mega-caps, semiconductor companies like Nvidia will retreat.
  • The second is accelerated monetization of AI applications. This would signal that we are moving along the monetization curve to the application layer, which is the most scalable. These use cases have not yet been fully developed, and we continue to monitor these trends closely. Once signs of this stage of the cycle emerge, we will shift our holdings to own infrastructure software names as well as look at who the winners will be on the application layer.

Wrapping Up

Mega-cap tech companies have become the new defensive. Investors are finding comfort in what has worked for the past couple of decades. But they’re also finding something else in Megcaps. Companies that are:

  1. Outgrowing the rest of the market on the top line.
  2. More profitable than most other companies on the bottom line.
  3. Incumbents will dominate the next technological shift.

We’re taking an approach where we are barbelling mega-cap holdings with those that are benefitting from physical AI infrastructure buildout. We will own more application/software businesses in phase two, but we are not quite there yet.

In next month’s issue, I’m going to dive into why we need to see more “R” on the back of heavy “I” when it comes to the ROIC mentioned above.

Strong convictions. Loosely held.

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—Nick Mersch, CFA


Sources:

  1. AAIG IT Services (June 2024): https://aag-it.com/the-latest-cloud-computing-statistics
  2. IEEE Spectrum (July 2024): https://spectrum.ieee.org/chips-act-funding

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Nicholas Mersch, CFA

Nicholas Mersch has worked in the capital markets industry in several capacities over the past 10 years. Areas include private equity, infrastructure finance, venture capital and technology focused equity research. In his current capacity, he is an Associate Portfolio Manager at Purpose Investments focused on long/short equities.

Mr. Mersch graduated with a bachelors of management and organizational studies from Western University and is a CFA charterholder.