We have invested in technology companies for over 25 years, but the incredible pace of innovation we are encountering today in the early phase of Generative AI adoption is unmatched. Thankfully, in addition to managing our two core Technology Funds (c$10bn+ AuM), we have benefitted from the invaluable experience gained in running a dedicated and differentiated Artificial Intelligence (AI) Fund, which we launched nearly seven years ago.

Our team of 10 dedicated technology fund managers and analysts, one of the largest and most experienced globally, applies an ’AI lens’ to all potential investments. This has allowed us to pivot the Funds rapidly over the past 12 months in a bid to capture the explosive growth and future opportunities presented by Generative AI while navigating the rapidly changing risks and volatility that are likely to remain an uncomfortable feature of the AI story, as is typical in the early stages of a transformational technology shift.

The recent technology correction

Technology stocks pulled back last month after a strong start to the year, on the back of hotter-than-expected inflation in the US and a pushing out of interest rate cut expectations for 2024 (from 6-7 cuts expected at the start of the year, to only 1-2 now). This and the concurrent jump in US 10-year yields – rising by 48 basis points in April alone – created a considerable headwind for growth stocks. The pain was most acute for longer duration stocks, however we feel this is a distraction at the start of a major long-term cycle, driven by Generative AI. In our view, the worst of the rate headwinds is clearly behind us, and at some stage declining rates will likely turn into a tailwind for growth stocks. Seasonality is favourable too with returns from here typically stronger until late summer.

AI spending signals strong pipelines across industry lines

Stickier-than-anticipated economic data has pushed out market expectations around the Fed’s cutting cycle, however our base case is it will likely follow other central banks in cutting interest rates this year as inflation trends back towards target. As such, we believe the sectoral reset we have just experienced offers compelling valuations for technology companies with strong growth potential. Most of the sector’s bellwether stocks currently trade at 20-35x forward earnings. While not cheap this is far from bubble territory and attractive, in our view, given the robust growth prospects we believe the sector offers.

Encouragingly, the scale of the positive capex revisions at the hyperscalers shows no signs of slowing. Hyperscaler capex this year is now expected to grow 44% year on year (y/y) to reach >$170bn, up from expectations of 26% (previously 18%), representing the fastest growth since 2018. AI servers will account for nearly 60% of hyperscalers’ total server spending, according to Gartner.  For us, this is particularly significant given the hyperscalers’ visibility into future AI products and the strong vote of confidence it implies in the ongoing improvement and future potential of an already extraordinary technology. These companies have delivered high returns on their investments over the past few years, and we take seriously the signal that a meaningful step-up in AI capex sends about the potential size and scope of the AI market in the future.

Meaningful spending plans on the hardware side, with new chips from NVIDIA, Advanced Micro Devices (AMD) and others, supply constraints easing and TSMC bringing on capacity to tackle key technology bottlenecks, combined with the imminent launch of ChatGPT-5 and other LLMs ramping into the second half of the year should offer powerful tailwinds. As such, we believe the age of AI has only just begun.

The incumbents’ dilemma

In our view, Generative AI is a rare example of discontinuous technology change. We are at a critical turning point where an entirely new compute architecture/stack is required and, as per earlier technology cycles, prior winners are unlikely to be the future leaders.

The large incumbents know what the technology is and what they need to do but their business models (like Search in the case of Google) are built around legacy technology. While a transition is possible, the current pace of AI progress threatens to widen the gap between leaders and laggards until it happens, not to mention the room it leaves for new entrants to gain a foothold, such as OpenAI, which recently unveiled an extraordinary text-to-video generation tool called Sora (the Japanese word for ‘sky’) to reflect its potential. Even a year ago, this quality of application was unthinkable and offers another reason why we are so excited by the pace of innovation in AI. In our view, it also highlights the extent to which AI could make or break investment performance over the next decade.

Source: OpenAI GPT-4, February 2024.

As is normal during new technology cycles, a change of leadership will undoubtedly follow. It will require an active investment approach and a deep understanding of technology change. Not only do we have one of the largest and most experienced technology investment teams globally, but we have more than six years of experience running a dedicated AI Fund.

This has already helped us pivot our core Technology Funds meaningfully towards the AI theme, and should also put us in a strong and unique position with our AI Fund which is differentiated by its focus on the AI beneficiaries beyond technology. Specifically, the AI Fund has a much broader reach into global equities, while focusing only on the growing number of stocks with a strong AI/data tailwind. Our focus is on companies in all industries embracing AI to either create new products or develop new markets, and/or drive significant cost savings and productivity benefits leading to superior revenue or earnings growth and hopefully valuation rerating. We are excited about the longer-term opportunity this provides, as we help our clients navigate the rapidly changing AI opportunities and disruption ahead. This becomes especially interesting as we move beyond the initial Generative AI infrastructure build phase (largely captured in technology). We are already seeing growing interest in this Fund (now $700m AuM) with strong inflows in the year to date, as AI tailwinds become primary reasons for outperformance of these non-technology beneficiary holdings. In part, this is also investors concern about the distribution/risk to AI in their core global equity portfolios - avoiding those companies negatively impacted by AI being a key challenge over the coming years. If we are correct, understanding AI impact may be more important than many other asset allocation decisions investors will face.

Viewing the world through our AI lens

It is not unreasonable to suggest AI could potentially prove to be the fork in the road, separating those for whom AI adoption propels growth from those who fail to appreciate its significance, or stumble in the deployment and eventually face cannibalisation.With our preference for investing in companies in the emerging phase of technology adoption, broader market participation and yet-to-emerge sector leadership away from the Magnificent Seven should play to our team’s depth of experience. That said, some of the larger stocks remain well positioned and should continue to drive strong underlying revenue and earnings growth, in turn supporting robust absolute returns. However, experience suggests a very selective approach will be required and this favours active management rather than ETFs or more passive strategies.

Even for us as ’AI maximalists’, the current pace of AI innovation is happening faster than we anticipated. Because of this not only do we see huge infrastructure spend ahead, but we also see the timeline to disruption both within and beyond the technology sectors being pulled forward. As always, our aim is to capture the underlying technology revenue and earnings growth potential, in this case infused by AI enablers and beneficiaries, while managing volatility through a diversified portfolio of growth companies. These are exciting times, and to us it feels much like 1995 – early in a major new technology cycle with strong growth ahead – however it is likely to feel uncomfortable at times too.