AI bubble or not: Resilient Tech Investing for your Portfolio

With the market trading near record highs, driven largely by big tech, valuations in parts of the market look expensive. Retail investors are still pouring into the technology sector, while some consultancies, like Mckinsey, are warning of the elevated costs required to fuel the sector’s continued growth. Some industry experts, including the Bank of England, are suggesting caution is warranted, while others, like Scion Asset Management’s Michael Burry, are pulling their money completely from the market.

The fact that over a third of the valuation of the S&P 500 is concentrated into just seven stocks, the Magnificent Seven, and 44% of the index is devoted to 30 AI-linked names, means that no one can ignore the fortunes of AI, nor are immune to it.

If this all sounds similar to the dotcom boom and bust, it’s not the first time the AI-boom has been compared as such.

But, it isn’t quite the same either as most AI bulls like to remind us.

Munro Partners’ Qiao Ma, one of the largest Australian backers of Nvidia, reminds investors that we are only three years into the AI-cycle, while there’s solid earnings and investment continuing to underpin the sector’s growth.

Similarly, Janus Henderson’s Alison Porter highlights that the AI cycle has better focused AI capital expenditure, more tech companies are profitable today compared to in the internet era, and there are stronger audit standards today. She also believes we are quick to forget the Y2K problems that forced mass accelerated spending.

With mixed signals in the market, it’s no wonder the experts are split on what’s happening.

One thing is certain though: we are living in uncertain times and there will always be winners and losers in the tech sector. The question then becomes: how do you select the tech stocks most likely to weather the storm?

Identifying Tech for the Long Haul – Looking at Quality and Resilience

Traditionally, quality stocks outperform the broader market over the long term, though on a relative basis they have suffered a sharp drawdown in the last year.

A simple definition of Quality revolves around the fundamentals of a stock – companies with strong balance sheets, consistent earnings and a high return on equity.

Many fund managers take the definition further for a more rounded view.

For example, Claremont Global like to consider competitive advantage and the long-term endurance of that competitive advantage as part of their assessment of quality. They’ll also consider the strength and experience of the management team. It’s not about investing in themes but choosing good companies.

Bear in mind that sometimes views on long term competitive advantage, and the performance of a management team can be subjective, which means while one fund manager might view a particular company as being high-quality, another might not.

Technology is 21% of the Claremont Global Fund Active ETF (ASX: CGUN) with Amazon and Microsoft both featured in the Top 5 holdings. Both of these businesses are part of the Magnificent Seven and have diversified and well-established revenue streams – AI is an enhancement to their offerings rather than their sole purpose, but both are also rapidly gaining market share in the cloud space.

Plato Investment Management similarly focus on quality stocks in the Plato Global Alpha Fund for long positions. The top five positions are tech dominated – Nvidia, Apple, Microsoft, Amazon and Broadcom.

The concept of durable competitive advantage is one that also comes up in other high conviction funds. Investors might ask themselves which aspects of the AI-boom are essential going forward and therefore which players are best positioned in that aspect.

For example, in the Firetrail F3 Global Opportunities Fund (ASX: S3GO), the semiconductor industry which is fuelling AI growth is one of their target areas. The fund invests in TSMC – the undeniable market leader, along with BE Semiconductor which produces equipment to manufacture and package semi-conductors.

Or alternatively, competitive advantage might be the strength of the service offering and contracts a company holds. If you consider Microsoft, it is dominant in both software and cloud which gives it an advantage over other players.

Another example of a company like this is German enterprise software firm SAP which services 99 out of 100 largest companies in the world and handles 77% of the world’s total transaction revenue. It is incorporating AI into its services. The Magellan Global Alpha Fund holds this as one of its top 10 positions.

Other Ways to Manage Risks

Rather than selective stock picking to avoid risks, some experts recommend making sure you are carefully diversified over many stocks. The idea is that if some fail, those that succeed can help you weather the challenges – you don’t have to ‘get it right’.

A few examples of broad tech index trackers include:

• Global X Morningstar Global Technology ETF (ASX: TECH) which invests in 25-50 companies likely to benefit from technology, particularly software-as-a-service, platform-as-a-service, infrastructure-as-a-service, cloud and edge computing infrastructure and hardware.

• Betashares Nasdaq 100 ETF (ASX: NDQ) which invests in the 100 largest non-financial companies on the Nasdaq market. More than 50% of the index is dedicated to technology and it holds all of the Magnificent Seven.

You could also look at the broader supply chain, such as the complete pipeline across semiconductor investing like the Global X Semiconductor ETF (ASX: SEMI), or the elements that go into chips like metals and mining.

Another option might be to step into themes like climate change which strongly benefit from AI but are not solely driven by it. An example of an investment in this space is the JPMorgan Climate Change Solutions Active ETF (Managed Fund) (ASX: T3MP).

Final Protective Methods

AI has become a significant driver of investment markets, so it’s unsurprising that investors will want exposure but also be wary of potential bubble risks.

Investors can consider being more selective in their approach to tech investing as one approach, with many fund managers considering quality characteristics to mitigate potential risks. Alternatively, they can take a highly diversified approach and simply spread investments across indices – while they’ll still take on the risk of companies that might fail, this is hopefully offset by successful companies.

There’s no foolproof way to invest in a theme, be it AI or any other, without taking on a level of risk. That’s true of investing in general. Ensuring your portfolio is resilient in the face of a potential bubble comes back to adequate diversification across all assets, sectors and styles, along with ensuring the strategy fits with your needs and circumstances. That way, you’ll be better positioned to weather whatever cycle comes.

Funds mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.