Artificial intelligence. It’s everywhere. Over the past week, I’ve had clients share that Chat GPT has mapped out an itinerary for a vacation to Greece, drafted a Letter of Intent for a new home purchase, and structured a back-to-school checklist. These ChatGPT examples provide a small sample of the opportunity set for how AI is likely to transform business and our daily routines over the years to come. Where there is opportunity, financial capital tends to follow. Which leads me to share how I am thinking about AI from an investment perspective.
A quick story from a recent conversation that I had with someone who was evaluating a role as employee #2 at an early-stage AI startup. “The vision for this company is that we would have < 30 employees at scale, raise a limited amount of outside capital, and generate $1B+ of enterprise value”. It’s a bold vision, but the advent of artificial intelligence certainly could make this possible. The reason I share this story: this is a very different type of company than a traditional venture-backed startup that raises significant capital to build & sustain the growth engine of their business to reach scale. I still believe the traditional model will exist as venture capital can accelerate a company’s ability to develop new products and gain market share ahead of competition. However, it did make me think that a new paradigm for company building could be underway, one that has a much leaner org chart due to the role that AI agents will play in businesses going forward. For anyone who pursues a startup that takes this approach, I view this as a net positive based on the following equation.
Smaller Org Charts + Less Capital Raised = More Equity Ownership Among Employees
Not everyone ascribes to the lean startup approach though. In fact, many investors believe the opposite as evidenced by the spending in research & development taking place at the largest tech companies, as well as the record breaking funding rounds for the private AI companies.
From an investment perspective, the excitement surrounding potential productivity gains that artificial intelligence will unlock has been a primary factor driving strong performance within financial markets this year. Based on current valuations and the amount of capital going toward AI investments, there is certainly a lot of exuberance surrounding this nascent technology and the companies that are considered to be the leaders in the AI race. That said, I am personally most encouraged by the conversations I’ve had with founders and individuals outside of the largest AI companies. Healthcare, financial services, and industrial systems, are all industries that have had very little technological advancements over recent decades. A byproduct of this has been slower growth and lower profit margins for these businesses, both of which are reflected in the investment returns for these sectors.
In the chart above, you’ll notice that a vast majority of the outsized returns for tech stocks have taken place over just the last five years. One reason for this is that interest rates were cut to near zero during the pandemic, which made higher growth industries much more attractive from an investment standpoint. In addition to the outpaced growth compared to other industries, the largest tech companies are also incredibly profitable. With these profits, they are plowing more money than ever before back into research & development to maintain their market leadership as AI emerges.
There’s no doubt the largest tech companies are incredible companies and they have a place within your investment portfolio. However, with this fierce competition, the question that I have been receiving more now than ever before is, “What if today’s largest tech companies are not the “winners” of the AI revolution”? Currently, the largest seven tech companies, also referred to as the “Mag 7”, make up as much of the S&P 500 index as the bottom 432 companies combined!
So if these companies are indeed the “winners”, anyone who has broad market exposure in their portfolio will reap the benefits on their current investment exposure. But maybe, there will be new companies that emerge as leaders over the next decade. The AI revolution shares many parallels to the internet boom. The companies that emerged as the dominant players were not the original internet companies such as, American Online, Yahoo, or Netscape, rather the most valuable companies came from the application layer of the internet – Google, Amazon, Microsoft, and Meta.
It’s possible that the same trend follows in the AI revolution. As companies apply artificial intelligence and new technology within the sectors that have previously been laggards with innovation, we may see some new leaders begin to emerge. For example, Harvey and Clio are early leaders leveraging AI in the legal sector, Ramp has developed agents to create efficiencies for corporate finance teams, and Komodo Health is using AI and data models to deliver more robust insights & predictive analytics on a patient’s health journey. As artificial intelligence continues to evolve and we see expanded use-cases that AI can deliver solutions, there will likely be new companies that are formed who emerge as leaders within a specific industry.
While there are mixed views on AI’s impact on business and society at large, as a long-term investor, I believe in taking an optimistic view of innovation and human ingenuity. While I won’t attempt to predict which companies will outperform, I believe there are timeless principles to investing that apply. A simplified framework for what I believe to be true about investing.
Companies are incentivized to deliver valuable products and services to consumers.
Companies who consistently deliver valuable products and services experience revenue growth. With positive unit economics, as revenue grows, profits increase over time.
Companies who increase profits attract investor capital. A byproduct of increased investor capital is a rising stock price.
When it comes to investing money on behalf of clients, I believe in taking an investment approach that is driven by fundamental principles that drive stock prices over the long-term. In the short-run, financial markets are driven by momentum and excitement for the future. However, when you stretch your time horizon over multiple decades, a company’s ability to translate revenue growth into durable profits for investors is the main driver of stock prices.