Discover more from The All-in-One Investing Newsletter
How Value Investing in AI and Innovative Technology works
Can Value Investors participate in the opportunities Innovative Tech like AI is offering? Of course they can! Here's how intelligent Investing in AI and Innovative Tech works.
The majority of today’s biggest companies are tech firms. This is a trend that is very likely to continue. It may not be the same companies on top of the S&P 500 in 20 years, but I would bet that the dominant industry won’t change that much.
AI has evolved at an astonishing speed over the last weeks and months, and it seems that we’re at a turning point similar to the early 2000s in terms of the development and application of AI.
As an investor, the urge to be a part of that growth is enormous. Hence, we already see price explosions of companies like Nvidia, which has almost tripled year to date and is up 230% from its low in October 2022. Its market capitalization surpassed $1T, and it trades at a P/E of 222. Safe to say, Nividia isn’t cheap.
This begs the question:
Has the chance to invest in AI at reasonable prices already passed?
The Right Time to Buy
The changes through innovative technologies are overestimated in the short term but underestimated in the long term.
The time to invest in AI at reasonable prices hasn’t passed yet. Think of the tech boom in 1999-2000.
Every company that put the words internet into its yearly report or earnings call went through the roof. Every company that ended with “.com” gained billions of dollars in market cap.
However, investors weren’t wrong about the drastic changes the internet will bring. They just came to the wrong conclusions. They bought companies detached from reasonable prices and valuations as part of a trend.
This type of herd investing is typical when a new trend emerges. An intelligent investor would’ve seen the potential of the technology but understood that this wouldn’t bring success to any company involved with that tech.
Value investing never loses sight of the interplay between the two most important things—the relationship between price and value.
I don’t need to tell you how 2000 ended.
But what about today? What about 2023?
Nvidia has a pole position in AI; however, they didn’t build this position overnight. Yet, only half a year ago, investors didn’t care about Nvidia’s breakthroughs in AI.
At these early stages of adopting new technology, investors are jumping on trends quickly and with little regard to how much the economic impact of this innovation will actually bring to a given company.
Because of this, prices are likely to come down again at some point in the future. This mostly happens at what I call the “doubt stage.” That’s the point in time where people have recognized what the technology can do but start to ask the question of what economic benefit this will bring in reality.
The economic benefit itself isn’t what’s in doubt mostly. It’s more the specific company that claims to use this technology to its advantage.
The concept I’m referring to is the Gartner Hype Cycle.
There are five stages in the Gartner Hype Cycle:
For an investor, it is crucial to know in which phase of this cycle we are.
If I had to guess, I would say that we’re between the Technology Trigger and the Peak of Inflated Expectations regarding the current state of AI.
Looking at the price inflation of Nvidia and some other firms, probably a lot closer to the peak.
If that’s the case, that would be phenomenal news for the intelligent, prepared investor.
The Prepared Mind
Opportunities come to the prepared mind.
When I talk about the prepared investor, what do I mean?
A value investor isn’t at the frontline of these innovative tech investments. This lies in the nature of his investment principles.
The future economic value of the technological changes is impossible to predict, and the quick hype that starts the betting on tech stocks is messing up the price.
It is, however, the job of an intelligent investor to educate himself on the possible outcomes and the opportunities that might present themself.
Gain more knowledge on the topic, research companies, and come up with a watchlist.
So when the “doubt stage” or to stay in the Gartner Model, the “Trough of Disillusionment” emerges and prices cool off, you understand the risks and rewards these companies offer.
Bill Miller did a fantastic job in the early 2000s when he discovered the enormous opportunities Amazon offers at a time when nobody wanted to own Amazon.
He made that call because he understood the power of the internet and the importance of looking into individual companies and assessing what potential the technology offers to that particular business.
Managing Expectations and Forecasting Growth
Garbage in, garbage out!
But how do you rightly forecast growth in an industry that is still at the beginning and thus highly unpredictable?
The easy answer is that you don’t. You won’t be able to predict the industry’s growth correctly, let alone the growth of an individual company.
You must take an educated guess and be aware that you’ll be wrong. That’s why the price is such an important factor here. It’s your downside protection.
You need a large margin of error. You can’t allow yourself to buy at prices that still reflect the hope of investors who started buying in the phase of Peak Expectations.
Those investors build models that make any company look like a big winner. It’s easy to put 50% annual growth rates into an Excel sheet and come up with trillion-dollar valuations.
And the veil of quantifiability hides the unrealistic assumptions made to come up with those valuations. There’s a saying for such models: Garbage in, garbage out.
When your forecast on the industry isn’t adding much value to your research process, finding the right company within the industry should become an even bigger focus of your work.
A common trend in the tech industry is the concentration of market share within only a handful of companies. That’s why investing in the right company within the industry is even more important than investing in the right industry in the first place.
That’s why growth rates of the AI industry aren’t that important to start with, we won’t know exact numbers, but we do know that the industry will grow fast and become an important part of our modern world.
Now we have to figure out what company benefits most from that.
And again, we can learn from history. The first mover hasn’t been the biggest winner in most tech innovations of the last two decades. So Nvidia isn’t through yet, although their position seems very strong.
To receive new Posts and Support my Work, consider becoming a Free or Paid Subscriber.
Finding the Winning Companies
Now this is the time when the strengths of value investors come to play. It’s about finding the handful of high-quality businesses among all the competitors in the market.
Your research should focus on the competitive advantages of a business, the quality of management, the financials, of course, and all that while paying close attention to the price of each company.
You want to invest in the best company but at the right price. The most important factor when investing in fast-growing industries and companies remains the relationship between price and value.
Investors like Buffett, Munger, Phil Fischer, or Terry Smith know that you might pay a premium for the best company in the industry, but it needs to be reasonable given your growth assumptions. And since those growth assumptions are rather vague and unclear, your margin of error must be appropriately high.
Terry Smith coined the phrase: “Buy once, cry once.”
Meaning that you might pay a little more than you would want for the business, but in return, you get the best company in the industry and won’t have any trouble with it for quite some time.
Think of buying a car. You can either choose a crappy, cheap one or a great one that’s more expensive. You cry once buying the better one, but you don’t need to worry about the car breaking down and needing repair every other week.
This is a concept of GARP investing (Growth at a Reasonable Price) that I generally agree with. However, this is more suitable for high-quality companies in mature industries—a company where you can reliably predict its future earnings power.
As I have mentioned many times now, this is not the case for AI or innovative tech.
So I'll say it once again, at the risk of being annoying, price plays a key role here, and you better not pay a price that brings tears to your eyes.
A Quick Reminder at the End
Let me close by using Buffett’s famous Baseball analogy. The beautiful thing about investing is that you don’t have to strike at every pitch coming your way.
As you might have noticed reading this article in the last couple of minutes, there are a lot of ifs and unknowns in investing in a new and fast-growing industry.
Not every investor feels comfortable with that type of investing. And you don’t have to.
Maybe you conclude that this investing style is not for you, and the companies you research end up on the “too hard pile.” That’s fine.
That’s it for today!
If you enjoyed this article, please Like and Share it so more people can see it!
You can also Support my Work here and on Twitter by becoming a paid subscriber. Thanks a lot to everyone who chooses to do so!