Artificial Intelligence (AI) has been the talk of the town lately. Investor enthusiasm over the potential has helped push the S&P 500 into a new bull market.
Today we’re going to look at why that is, how AI enthusiasm is dramatically influencing large-cap stock valuations, and what investors need to see (not just hear) from management teams pitching AI potential in the upcoming Q2 earnings season.
Let’s dig in.
Famous Last Words: Why This Time Is Different
Exciting, technology-led stock rallies often seem to be driven by smaller, more speculative companies that lack revenue and earnings but have seemingly huge potential.
Think of the dot.com bubble, the years-long rally in cloud software stocks and the crypto craze.
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What makes the current AI-fueled stock market rally different is that, while there is plenty happening at the small end of the market cap curve, it is being led by the largest and most profitable tech companies in the world.
Moreover, leadership is not just talking about what could be done someday. They are starting to charge for their AI technologies today.
Microsoft (MSFT) is the best example. Early this week the company announced it would start charging $30 per month per user for Microsoft 365 Copilot. Copilot was announced back in March and brings AI tools into Microsoft’s productivity suite (Excel, Word, PowerPoint, Outlook, etc.).
Word on the Street is that while Copilot was in private preview users were blown away. That likely fed into the $30 per month fee, roughly triple the $10 rate that many analysts had expected.
Now, we could go on and on about how this is extremely bullish for Microsoft – a stock I added to my Cabot Early Opportunities advisory service back in February – but that’s a discussion for another day.
And while the cost burden of upgrading capacity and running such intense processes might be part of the reason for MSFT’s high Copilot price, the bottom line is it sets a higher pay threshold that could benefit other infrastructure and software stocks releasing powerful AI solutions.
That leads to a discussion of exactly what other companies have those AI solutions. In addition to Microsoft, I am following a number of lesser-known small and mid-cap software companies that appear to be on the right track. You can learn more about those specific companies here.
Switching gears every so slightly, we also learned this week that Meta Platforms (META) will be making its AI model Llama 2 available for free for research and commercial use. This is notable because Llama is an open-source alternative to the OpenAI tech behind Microsoft’s Copilot.
For now, for most use cases, Meta won’t generate any revenue. But, because it’s open-source it’s also benefiting from a worldwide developer base that’s building on the foundation model.
In short, Meta is taking a different route with its monetization efforts for Llama 2 than that which Microsoft is taking, but which may be more aligned with its own vision to provide technologies that connect people around the world.
Also, Meta and Microsoft announced that Llama 2 is available on Microsoft’s Azure cloud platform, which adds another fascinating wrinkle to the AI landscape.
Zooming back out, the takeaway is that this AI-fueled market rally is being led by the biggest of the big. The credibility that comes with that can’t be overstated.
Valuations: Looking at Large Caps With AI-Tinted Goggles
The S&P 500 Index currently trades with a forward PE of around 19.2. That’s including the 27% weight of the MegaCap-8, which, as just discussed, includes several stocks leading the AI-charged rally.
The MegaCap-8 has a forward PE of 31.2. Take them out and the S&P 500 has a forward PE of just 16.7.
Clearly, these stocks and their 27% weight in the index are having a big impact on the large-cap index valuation, which is well above the historical fair-value PE of 15.0.
The question is … is AI distorting investor perspective of what a reasonable valuation for AI stocks should be? Or are investors acting rationally?
Let’s revisit that in a few months.
Q2 Earnings Season: Where the Rubber Hits the Road
Data from FactSet says that in the Q1 2023 earnings season, 110 of S&P 500 companies (over 20%) used the term “AI” on their earnings call.
I don’t know exactly how many small and mid-cap companies used the term. But among the software companies I follow I think maybe … all of them?
In other words, any company with a marketing department and any potential exposure to AI and/or AI innovation talked about it. If they didn’t bring it up, an analyst asked.
In most cases, those discussions were greeted well. But, in the upcoming Q2 earnings season, analysts and investors will be a lot more demanding.
It’s not that we’re expecting every company to have AI in its tech stack right now and be charging for it. That’s not realistic.
But those management teams that want to be in the game need to present a clearer roadmap, along with some sense of the associated revenue, profit and/or key performance indicator (KPI) benefits, for their company’s stock to get a boost.
In short, AI is turning from a “tell me” into a “show me” story.
To learn exactly which small companies I think will succeed with AI, grab a subscription to Cabot Small-Cap Confidential today.
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