IRBO - AIQ: Positioned For Strong Gains Next Year If You Like AI

2024-01-03 05:25:22 ET

Summary

• The stock market has performed well this year, with gains concentrated in the last two months, particularly in AI-related stocks like Microsoft and Nvidia.
• The Global X Artificial Intelligence & Technology ETF is well-positioned to benefit from the continued optimism for AI in the coming year.
• Fund flows into AIQ suggest growing investor interest in AI-focused investments beyond the popular Magnificent 7 stocks.

Investment Thesis

The stock market has performed exceedingly well this year, up almost 25% on a year-on-year basis. While 2023 was a year of cat-and-mouse where the general stock market's outlook was based on the rapidly changing views of economists, in the end, consensus did manage to prevail amongst economists, regulators, and market participants that the economy may have avoided a recession with a strong GDP accompanied by downward-trending inflation.

Most of the market's gains were seen in the last two months of the year, with the S&P500 rising ~16% in the last two months and the technology-focused Nasdaq100 index also rising by the same amount since November this year. Much of the conversation focused on the gains seen in the Magnificent 7 complex of stocks and their capabilities revolving around AI. The boom in AI services and integrations has led to a surge in renewed optimism in stocks like Microsoft (MSFT) and Nvidia (NVDA).

However, I believe that most of these stocks may have outrun themselves and will lead to investors looking for opportunities elsewhere in the stock market. With the optimism for AI to continue into next year, I think the Global X Artificial Intelligence & Technology ETF (AIQ) is in prime position to secure gains for next year.

About AIQ

The Global X Artificial Intelligence & Technology ETF is issued by Mirae Asset Global Investments. The ETF is designed to track the performance of the INDXX ARTIFICIAL INTELLIGENCE & BIG DATA index. By tracking the index, the fund's goal is two-fold: -

• To invest in companies that benefit from the deployment and utilization of AI in their products and services. Examples of companies in this space reside in sectors such as Cloud Software, Enterprise Software, Information Technology Services etc.

• To invest in companies that sell hardware designed to process the data that most AI software solutions rely on. Examples of companies in this space are usually in sectors such as semiconductors, memory storage chips, etc.

I have added a chart below that shows the Top 15 Holdings vs. the Constitution of AIQ's Funds by categories.

Peer comparison

Here is how AIQ compares with some of its peers. The list below is ordered by largest-to-smallest fund in terms of Assets Managed.

Although it is not larger than other ETFs in terms of Assets Managed, it is worth noting that the fund has been able to deliver consistent returns over the past year.

Why AIQ is the best ETF for AI-themed investments

While this section of the post is not necessarily aimed at advocating the need for AI-focused stocks to be part of your portfolio, I will highlight a few studies by PwC and McKinsey that have done a great job at quantifying the impact AI in general will have on GDP. I will use forecasts from these reports in a later section to estimate my price targets for AIQ. For now, the biggest advantages companies have from deploying AI are seen in widening margin expansions due to higher labor productivity and lower labor costs. Companies like IBM (IBM), Dropbox (DBX), and, most recently, Klarna (KLAR) have already made changes to their labor workforce because of productivity gains seen as a result of AI deployment.

While 2023 was a big year for the Magnificent 7 stocks, it was really Microsoft and Nvidia that became the faces of 2023's AI revolution. While Microsoft took their partnership with OpenAI to new heights and dominated the AI Chat Assistants space, Nvidia became the face of surging chip demand for AI solutions, leading to a scarcity of AI chips . I suspect many investors will lock in their gains and re-allocate their fund capital into other AI-focused areas of the stock market.

Mag-7 Stocks will be Lapping Strong y/y Comps in 2024

Both of these companies have significantly run far ahead this year, with Microsoft's non-GAAP forward PE stretched at 35 and Nvidia's non-GAAP forward P/E even significantly more outstretched at 41. For the sake of benchmarking expectations, FactSet estimates the forward price/earnings multiple for the S&P500 at 19.3. This is after Nvidia saw its net income skyrocket 1260% while Microsoft's net income surged 27% . I firmly believe that next year will be tough for these companies to continue to produce outsized returns, and investors will be on the lookout to deploy their capital elsewhere.

Fund Flow Charts Suggest Strong Inflows into AIQ

Fund Flows are essentially investor capital that flows in or out of financial assets over a period of time. Typically, fund flows are looked at to observe where investors are deploying their money or pulling their capital out of financial assets. While it does not necessarily illustrate the performance of the financial asset, I observe fund flows purely as a forward-looking tool to gauge the shifting trends of investor sentiment and observe which financial assets (ETFs in this case) investors are parking their money in. The higher the flow of funds, the higher the rising sentiment for the ETF.

In the case of AIQ, we can see that there has been a growing trend of funds flowing into the ETF vs. its competition.

To me, this is a positive development for AIQ and signals that more investors are looking at alternatives to AI-focused investments rather than concentrating in ETFs that continue to focus on the Magnificent 7 stocks.

Valuing the AIQ ETF

In order to understand how to value the AIQ ETF, I studied the effects AI would have on the world economy and how it would affect the world's GDP output. My rationale for analyzing the economic impact of AI was simple: by deploying AI into organizational workflows, companies allow employees to save more time and can channel their employee resources to work on more meaningful projects that add significant upstream value to the company. This increases labor productivity and reduces labor costs, which adds incremental savings to the company's bottom line in the form of enhanced earnings. Collectively, the increased earnings from productivity gains due to AI end up boosting GDP. We have already seen how a few companies such as Nvidia and Microsoft's earnings surged due to higher enterprise AI adoption, particularly in the case of Nvidia which saw its net income surge 1259% on a y/y basis. As adoption & demand for AI across enterprises and retail users deepens, more companies are expected to roll out competitive AI cloud solutions and semiconductor chips to match up to demand. Innovation in AI which was concentrated, for the most part of 2023, to a few companies will broaden out to more enterprises. For example, Intel ( INTC ) launched their own line of Gaudi3 chips , while AMD (AMD) have released their line of M1300X chips to rival Nvidia's recent GH200 chip. Both AMD and Intel have been outperforming Nvidia on a month-to-date and quarter-to-date basis, as seen below. Incidentally, Intel is the top holding of the AIQ fund at the time of writing this research note.

Now, to estimate a price target for the AIQ fund, I will use the estimated gains in GDP due to AI to calculate potential gains in the AIQ fund. Therefore, working backwards, I reviewed a research report by PwC that suggested AI will provide a 14.5% boost to the U.S. GDP by 2030. Today's price for the AIQ ETF stands at ~$31.5. The ETF is currently valued at 25x earnings. Assuming there is no change in the P/E, if we multiply the 14.5% we earlier calculated into the earnings side of the PE equation, we can also multiply the same gains into the price side of the P/E equation as well. With those calculations, I estimate ~$36 to be the new target price of the AIQ fund.

I do believe the boost in GDP from AI deployment to be slightly conservative, given the gains some companies have already seen this year in their net income. Other studies from Morgan Stanley show a 26% boost in income by 2030 .

Risks to bull thesis

Dollar Reverses Higher

As is the case with most technology stocks, a stronger dollar would not bode well for the basket of stocks that make up the AIQ ETF. The U.S. Dollar Index trending lower, which has been very advantageous to most technology stocks and growth stocks in the past 2 months. If the U.S. Federal Reserve were to switch gears to an even higher interest rate environment, the dollar would reverse course, moving higher from current levels, which would be detrimental to the stocks in AIQ.

Macroeconomic Strength Outlook deteriorates

Currently, the U.S. Federal Reserve projects the U.S. economy will grow 1.4% y/y per the most recent meeting notes 2 weeks ago , while Goldman Sachs is more optimistic by expecting the U.S. GDP to grow 1.8%. Markets seem to have priced in these forecasts, currently trading at 19 times forward earnings as per FactSet .

Morgan Stanley also believes the U.S. economy will be growing in the same growth range of around 1.9% next year. However, they have also listed caveats that threaten the outlook, with the U.S. slipping into a shock recession next year. Were the recession scenario to play out, capital spending would arrive at a standstill, and most companies would suddenly push out plans for their AI deployments into 2025 and beyond. Expect all stocks in the AIQ fund to be hurt by the negative sentiment if this happens.

Conclusion

Current growth trajectories in the economy, combined with a huge appetite for increasing corporate spend on AI projects, are bound to provide strong tailwinds to stocks that currently make up the AIQ ETF. Moreover, AIQ's investing objectives to invest in companies that produce AI software solutions and/or semiconductor chips for AI solutions position this ETF to be ready to benefit from secular trends in this space, which makes this ETF a buy.

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