Are AI Companies In A Bubble At The Moment?

Are AI Companies In A Bubble At The Moment?

Investing isn’t easy in the best of times, investing in a hyped sector can be downright dangerous. It’s easy to get caught up in the recent market darlings from mining stocks linked to the electric vehicle revolution to finance stocks that were involved in the buy now pay later bubble. Even the cannabis industry experienced some serious hype in recent years.  Some of these investments pay off, most don’t work out or take a long time to pay off. 

Bubbles or frothy investment conditions also spread across the market as a whole. Going back through history, if you made an investment in most stock markets in November/December 2021, in March 2020, March 2000, even in September 1987 and checked your portfolio a month or so later and you’d have seen a lot of red in your portfolio! 

Given the market’s recent exuberance towards AI, particularly since the generative AI program chatGPT was released to the world in November 2022, it’s a question that many are asking, are AI companies in a bubble at the moment? 

A recent CNBC article about U.S chipmaker Nvidia noted “Nvidia reported first-quarter earnings for its fiscal 2024 on Wednesday, with a stronger-than-expected forecast that drove shares up 26% in extended trading.” Whilst the numbers that Nvidia reported were basically in line with what the markets were anticipating it was the forecast numbers that shocked the market and led to a surge in buying leading to the 26% share price bump. 

This isn’t the only example of a listed company riding the AI wave, the Microsoft share price has increased by over 30% year to date in part because of its closeness to chatGPT owner Open AI while the Alphabet (parent of Google) share price has increased over 35% YTD and Dutch chip maker ASML’s share price is up over 20%, both in part because of their exposure to the AI industry. 

Look for quality companies to invest in

While frothy investment conditions can lift all listed companies in a sector it’s important to make sure that you invest in quality rather than throwing darts at a board. Do some research on who is running the company and what their previous work experience is. Look at what products the company offers or is close to bringing to market, are these or do they appear to be market leading products or at least products that will shake up or disrupt industries or sectors?

This also means to tread carefully around “blue sky” type businesses that don’t really have a product or generate much revenue or profit. With all these companies and start ups rushing into the AI world, some will deliver, many won’t. Like the gold rush in the 1800’s, many tried to make their fortune searching for gold, most of the money made during that time was from selling equipment to the miners. 

Some market commentators see something similar with AI. Explaining the recent Nvidia share price surge after the increase in guidance numbers, an Australian Financial Review article stated, “There are two ways to look at Nvidia’s guidance and the reaction to it. The first is that it is proof that in the picks-and-shovel section of the AI sector, demand is growing extremely quickly.

So one strategy to invest in this latest “gold rush”, is to find quality companies and experienced businesses selling quality equipment to the AI industry.  

Is the company at a reasonable valuation?

While technology company valuations can be rather lofty (particularly when compared to financial or industrial sector companies) don’t let this dissuade you from investing in a company or a sector. For most of its listed life Amazon has traded at a very high multiple of its earnings,  however it has consistently outperformed these lofty valuations. 

A 2021 CNBC Make It article illustrated the recent performance of Amazon shares stating “if you invested in Amazon back in 2011, your investment would still be a blockbuster success. Over the past decade, the stock has grown 1,588%, with Amazon’s market cap growing from $88.1 billion to $1.7 trillion.

Another example is Netflix which also had very high valuation multiples yet consistently outperformed these very high valuations. So not only do your due diligence on the company, do this on a top down approach assessing the financial environment, the sector and also doing your best crystal ball impersonation to determine whether the company can exceed these high valuations. 

So are AI companies currently in a bubble?

Yes and no. AI seems to be a totally transformative technology with many different uses for many different industries. Many commentators and industry participants are claiming that AI could be as disruptive as the internet was in the late 1990’s/early 2000’s. That kind of hype attracts money, a lot of money!

If you look back at the crazy dot com valuations on companies in the late 90’s and early 2000, people were buying the hype and after the dot com crash in 2000 many of these companies became worthless or lost a lot of money. The survivors, such as Amazon came through this period as dominant players and that is what early AI investors are hoping for, trying to find an “Amazon” in the AI world.  

The same can be said for Google and Facebook, which for years analysts and market experts struggled to correctly value. With the occasional blip (at least before the end of 2021) they continually surpassed these and became online monsters in their respective industries generating a lot of money for their business and their shareholders. 

So do your best to value these AI companies but also keep an eye to the future and how transformative AI appears to be. 

Remember to not invest any money that you can’t afford to lose and any investment should be part of a strong financial plan that includes sufficient savings, a quality and diversified investment portfolio (that you are regularly adding to) and is a stand alone investment meaning if it doesn’t perform or goes to zero doesn’t affect any other investments or holdings in your portfolio. 

If the investment is more speculative this should form a smaller part of your investment portfolio given the higher propensity for this type of investment to fail or under-perform. Do your research, dig deeper if your experience is lacking, reach out to professionals or experts in this field to improve your knowledge and understanding and if all your ducks line up, invest in your chosen company.