US Equity Roundtable

Investing Beyond the AI Darlings

17 August 2023
8 min read

Three of our US equity portfolio managers discuss market conditions in 2023 and provide perspectives on positioning for the challenges ahead.

US equities have rallied in 2023, but investors are facing tricky conditions. Market gains have been dominated by mega-cap tech stocks, which benefited from investor perceptions that artificial intelligence (AI) could potentially drive superior long-term earnings growth. GDP growth has recently exceeded expectations and inflation has fallen, yet interest rates remain high. We asked three of AB’s equity portfolio managers to comment on the market environment and how they are positioning portfolios to find sources of long-term return potential.

Q: Market returns have been driven by a small group of mega-cap stocks this year. What are your thoughts on market concentration?

John Fogarty, Co-Chief Investment Officer, US Growth Equities: Market concentration has challenged investors like us who believe in the spirit and letter of diversification. We’ve seen periods of narrow market returns before, and they don’t tend to sustain for very long. This episode of market concentration has been incredibly extreme—I like to think of it in terms of market capitalization. Apple’s market cap increased by $1 trillion, and Tesla added $500 billion. We’re talking about $4.5 trillion across the top seven names, which is more than 10% of the entire equity market. These are mind blowing numbers, and at some point, I would expect these gains to reverse—or at least consolidate—as the market broadens.

James (Jim) T. Tierney, Jr., Chief Investment Officer, Concentrated US Growth: We’ve seen this kind of concentration in the past, but we’ve never seen it concentrated so tightly in one industry—technology. Recently though, the market has started to broaden out—the 10 largest stocks contributed 104% of the S&P 500’s return from January through May, but through July, they contributed 69%. This is benefiting active management. If you look back to three previous years when most of the return came from just 10 names, there’s some good news—the year after this happened, the pendulum swung back, the market broadened out and our Concentrated US Growth portfolio’s performance improved.

Q: Excitement over AI has been a big catalyst for the technology and internet titans. How should equity investors approach the AI trend?

Ben Ruegsegger, Portfolio Manager—Sustainable US Thematic Equities: We’ve been invested in AI for about 10 years and have held a position in NVIDIA, the chipmaker, for quite some time. But part of what we do for our clients is to look beyond NVIDIA, which has been one of the biggest direct beneficiaries of AI to date. We look at the entire ecosystem to find companies that are enablers of this technology. For example, AI is very energy intensive and many companies are looking for energy-efficient ways to deploy the technology. Monolithic Power Systems is a power semiconductor firm that takes a lot of components and integrates them into smaller solutions, which makes them more energy efficient and generates significant energy savings for clients. Companies like these will benefit over time from the proliferation of AI but are not necessarily in the spotlight for investors today.

Jim: At some point, investors will become far more skeptical of the AI ramp up. So, we must really dig in to determine which companies have real AI business models and which ones just have an AI halo. Beyond the small number of companies like Microsoft and NVIDIA who enjoyed a big boost this year, we need to search for the real beneficiaries of AI. Do you believe that seven or 10 companies will monopolize the benefits of AI, or is AI a productivity tool that helps everybody? When implemented strategically, AI could generate big productivity improvements, which translates into cost savings and enhanced earnings. Over time, it could lead to a reduction in demand for labor—which is a big constraint in the US economy today. This, in turn, could lead to lower inflation and lower interest rates. So, there are many knock-on effects to AI that the market hasn’t even started to discount, and over time, I think that will benefit the broader market—not just the top 10.

John: I’m not denying that something huge is happening with AI. But we don’t want to assume we know all the winners. We want to verify it with actual results. In the case of NVIDIA and Microsoft, which we hold in our US Growth portfolios, we’re monitoring the details they are providing for their AI plans, which allows us to build out a model with higher certainty of revenue acceleration and profit accretion as they infuse AI in their products. Ultimately—for any company we look at as a beneficiary of AI—the share price, performance and valuation must conform with profit generation. We don’t want to pay for hope. We use our research to invest in growth companies with quality business models, and in some cases, AI provides optionality that is not yet embedded in the stock price valuation.

Q: Beyond AI, what other themes, trends or company-specific stories do you see in the market that can provide investors with strong long-term growth potential?

Ben: Our Sustainable Thematic and Strategic Research portfolios invest in long-term thematic trends that should persist through changing macro conditions. And we’re always evaluating theme progress to make sure we are targeting the right themes and the companies most levered to these durable opportunities. Energy transition is likely to be a durable theme that should benefit from increasing government support for clean energy and efficiency efforts in the private sector. Last year was the first time that the amount of money invested in the transition away from fossil fuels exceeded the amount of money funneled to fossil fuels. Healthcare is another industry in which long-term trends are creating opportunities, from task automation to personalized medicine to government efforts to reduce costs. Electric vehicles (EVs) are poised for long-term growth, but we prefer to reduce some of the volatility around the theme, so instead of trying to pick the winning carmakers, we prefer to invest in the enablers that enjoy revenue growth from increasing content growth per vehicle.

Jim: We take a similar approach when we look at some of the big trends. We like “picks and shovels” makers rather than trying to pick the winners. So, for example, with EVs, it’s very hard to know which carmakers are going to be the leaders. But companies that provide equipment for vehicles, such as Eaton or Amphenol, will benefit from increased demand for EVs, in our view.

Our Concentrated US Growth portfolio holds about 20 companies, and we look for companies that offer differentiated sources of earnings growth, which can do well in a variety of macroeconomic scenarios. Companies that we hold in the portfolio provide diversified opportunities derived from a range of sources—from Mexican beer sales to cellular towers to the growth of data usage around the world

John: Our philosophy balances profit and reinvestment opportunity, which we can find in different parts of the market. Cybersecurity is an interesting part of the technology industry; we hold CrowdStrike, a profitable and fast-growing cybersecurity leader that we believe will continue to benefit from an ever-expanding attack surface, as well as from advances in AI. CrowdStrike was early in using traditional AI to detect anomalies and is now pressing ahead with generative AI functionality that will further enhance its abilities to catch threats. In healthcare, we see several attractive long-term growth trends that aren’t vulnerable to drug-pricing volatility, including robotic surgery and animal health. Growth can be found in surprising industry segments. Think about auto salvage, which might not sound very exciting. But a company like Copart offers attractive asset growth at surprisingly high double-digit returns on capital, and benefits from a network effect by winning business from major insurers and profitably by shipping banged up cars overseas.

Q: The macroeconomic backdrop to markets looks challenging, as interest rates are expected to be higher for longer, even though inflation has fallen sharply. What does that mean for equity investors?

Ben: Interest rates are a blunt tool, and they tend to work over time. And the Fed has been embarking on a historic rate cycle, raising interest rates at an unprecedented pace. We came into the year believing that there would be an effect on the economy, and we saw some of the effects in the banking system earlier this year. If the economy does slow because the availability of loans becomes tighter or the cost of borrowing has gone up, it will be felt in the corporate sector and earnings as well. The good news for us is that for our portfolio to be successful, we don’t need to get the macro outlook exactly right. We’re invested in secular transformations that are likely to progress and deliver growth even if GDP growth is challenged.

Jim: The US Federal Reserve and central banks around the world have been effective. They’ve brought down real inflation significantly. I think that gives the Fed the flexibility to really slow down the pace of hikes as we go forward. The market is certainly discounting that. So, what does this mean for earnings? If nominal GDP is much lower, overall revenue growth for corporate America will be lower, yet the cost pressures are still there. Taken together, this means there will probably be more earnings pressure as we go forward. This has started to play out in consensus number cuts for the broader market in June compared to the stability from March to May. As earnings estimates tick down again, being selective, and finding reliable sources of long-term secular growth, will be incredibly important for equity investors.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

References to specific securities discussed are not to be considered recommendations by AllianceBernstein L.P.

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