Why AI justifies expensive tech valuations

Technology shares have become more expensive this year, but a leading investor in the sector argues that the promise of artificial intelligence (AI) justifies higher valuations.

Polar Capital Technology Trust manager Ben Rogoff points out that the outperformance of technology linked to the excitement around generative AI has seen the forward price-to-earnings (p/e) ratio of the tech sector grow from around 20 times at the start of the calendar year to around 24 times at the end of October. This is ahead of both the five-year and 10-year averages, which sit at 23 and 20 times.  

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Generative AI is the technology behind OpenAI’s ChatGPT tool, which can answer questions, help with computer programming, and even solve maths problems.

The increase in valuations has come as tech share prices have risen faster than forecast earnings. Winners from the AI boom, such as chipmaker Nvidia, Microsoft and Alphabet have risen 225%, 55% and 34% this year.

This year, the Nasdaq 100, which can be taken as a proxy for the tech sector, has risen 50% in US dollar terms.

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However, Rogoff says that the hype is justified and AI will have a meaningful impact on inflation and productivity, and ultimately profits for companies involved in it.

As such, he has positioned his portfolio so that three-quarters of it are AI enablers and beneficiaries.

Rogoff said: “While it is still early days, we are seeing encouraging signs for the adoption of AI and the impact of the AI transformation on companies up and down the supply chain.”

He says that AI services accounted for 3 percentage points of the year-on-year growth of Microsoft’s cloud computing arm, Azure, compared to just 1 percentage point last quarter, indicating a $1.5 (£1.2 billion) annual revenue figure.

“Microsoft Azure-OpenAI customers increased to 18,000 from 11,000 last quarter, and 40% of the Fortune 100 are trialling the M365 Copilot product (which launched on 1 November). Meta Platforms Inc Class A (NASDAQ:META) spoke to a mid-single digit increase in time spent on their main platforms due to AI-powered recommendation improvements. Meanwhile, Alphabet said generative AI projects on its AI Vertex platform were up seven times from last quarter,” Rogoff said.

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Analyst Numis notes that the past six months were busy for the trust, as it repositioned to profit from the growth of AI.

It notes that trades included adding several holdings in the semiconductor industry such as memory-related companies Micron Technology, Rambus, advanced packaging BE Semiconductor Industries, testing firms Advantest, Camtek and electronic design automation software Cadence Design Systems and Synopsys.

New investments were also made in smaller Asian component and materials companies, which the managers believe play an important role in AI chip and server manufacturing, while software exposure was repositioned towards companies that the managers believe are best placed to monetise AI, such as Adobe Inc (NASDAQ:ADBE) and Monday.Com (NASDAQ:MNDY), according to Numis.

Sales included companies in interest-rate sensitive areas such as fintech, full sales of Adyen, GMO Payment Gateway and alternative energy, which saw Enphase Energy and SolarEdge Technologies, leave the portfolio.

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Rogoff adds that generative AI could lead to “remarkable” productivity gains over the coming years, which may exert significant downward pressure on prices. 

He said: “Today, policymakers are focused on stubbornly tight labour markets just as AI threatens to disrupt as many as 300 million jobs. While this could yet take the form of dystopic science fiction and even civilisational decline, remarkable early gains from generative AI and the broad applicability of this nascent GPT (general purpose technology) suggests to us that we might instead be on the cusp of the ‘best decade ever’ for productivity growth.”

Polar Capital Technology Trust shares rose 10.6% in the six months to 31 October 2023, and the net asset value increased by 12.1%. The trust currently trades at a 13% discount.

Numis said: “We continue to rate Ben Rogoff highly and think that Polar Capital Technology is an attractive way to gain diversified exposure to global technology stocks. Given the nature of the sector, it is unlikely to be a smooth ride for technology investors, however we think that the long-term outlook is positive.”