Best Sectors for AI Investing

Brit Ryle

Posted October 11, 2023

I guess we can say that it’s still early days for the Artificial Intelligence revolution. Of course AI is hardly a new thing at this point. Seems like every other headline from the financial media has something to do with AI. And my email inbox is crammed with promotions for the next AI stock winner…

Right now I’ve got subject lines promising – Tech Expert: This AI Stock Will Crush Nvidia, $1 Billion Manager Unveils Breakthrough AI and Hottest AI Play of 2023 (Not Nvidia!).

I expect your inbox probably looks similar…

Because when a tech trend as powerful as AI comes along, it’s like manna from heaven for the investment newsletter subscription biz.

And let’s not kid ourselves – the productivity gains that will be created by AI’s ability to assimilate massive amounts of data really are revolutionary. 

Bank of America estimates that AI will boost U.S. GDP by 21% over the next 5 or 6 years. For a mature economy that typically grows in the 2%-3% range, that’s a huge improvement.

The size of the AI market itself – which includes AI software, AI hardware like chips and AI services – will nearly double, from this years total of $550 billion to $900 billion in 2026:

Research firm Accenture believes that AI will double global growth rates over the next 10 years. 

And that is why investment in AI started surging in 2020:

One note about this chart: You’ll notice that this does not include AI investment in AI numbers from 2022. AI investment was down ~25% in 2022, and that’s a direct result to the Fed’s interest rate hikes and the resulting bear market of 2022. No doubt 2023 will show a return to the uptrend for AI investment. 

The point is: investment in AI has only been surging over the last couple of years. And the first wave of the AI stock rally that started when Nvidia reported that its AI chip sales were twice as strong as anyone thought is only 7 months old…

To repeat, yes, it is still early days for the AI revolution. And the real economic benefits to U.S. GDP are yet to come. 

This is a good time to ignore the pie-in-the-sky promises of the “next big AI stock” and focus on realistic ways that AI will boost the economy and, more importantly, which stocks will benefit.

The Winners You Know

Look back to that last chart, about investment in AI. 2021’s total investment was $179 billion. Even with the bear market-related decline in investment to ~$135 billion in 2022, we’re still talking about a very large number. 

The investment is being made in new chip technology and capacity… In new and upgraded software programming to manage massive amounts of data… In new servers and data centers to house data-banks and run software… In companies integrating and testing AI data services for their own operations…

Given the size and scope of the investment that’s driving the AI market, we’re talking about big companies. There aren’t likely to be very many small start-up types that have an “A-HA!” moment and suddenly capture a meaningful share of the AI market. 

In other words, the promise that some unknown company is going to “crush Nvidia” is pretty much a fantasy. That’s not to say there won’t be unknown companies that carve out a niche and see their stock prices make massive gains…there will be, and we’ll talk more about that later in this article…

But think of a company like OpenAI, the one that created ChatGPT and exploded on the scene about a year ago. I’m sure it seemed to a lot of investors that OpenAI sprang up all of a sudden out of the blue. 

Truth is, OpenAI was founded in 2015 by a cast of heavyweights – Elon Musk, LinkedIn founder Reid Hoffman, Palantir founder Peter Thiel, Amazon’s Web Services and its CEO Sam Altman. Not your typical start-up – more like a “who’s who” of tech. Microsoft invested $1 billion in 2019 and another $10 billion earlier this year…

Much of the groundwork for the AI revolution has already been laid by companies that already exist. Now the market is at the point of implementing the technology and realizing the promise of productivity gains. 

The AI winners will mostly be companies you already know. 

The Cutting Edge of Productivity

Productivity basically means doing more with less. It is a double-edged sword that cuts both costs and jobs. 

The last time the U.S. enjoyed a significant jump was during the Internet Revolution. The rise of the PC and connectivity let people do more in less time – exchanging documents via email instead of courier, accounting with spreadsheets, online tax forms, online travel booking, online shopping – the internet was very convenient.

Yes, some jobs were marginalized, even eliminated. But on balance, the employment market wasn’t affected dramatically. 

The AI revolution is going to be a little different. Sure, there will still be a convenience factor for humans. But sad to say – the AI productivity boost will also come from simply eliminating a bunch of humans from the workforce and replacing them (us) with robots and software.

The moral hazard of replacing a large swath of the workforce with various forms of automation is self-evident. While it would be nice to think that our elected leaders responsible for making the rules might take the lead in mitigating the potential damage that will mostly hit the unskilled workforce, the fact is, they’ve long since abrogated their responsibility to Corporate America.

I didn’t really intend to venture into the dark side of AI, so let me snap this discussion back on track with the simple observation that the genie is out of the bottle. As investors, our best plan is to make the best decisions we can regarding AI and how to invest our money… 

Focus on Margins

The benefit to increased productivity will show up in profit margins. A look at companies that will likely have the biggest increase to their profit margins should be a good place to start. And I’ve got a nice graphic (also borrowed from the good people at Bank of America) to help show us the way: 

The pie chart here illustrates what I’ve been saying about productivity. 60% of companies say they plan to use AI for operational efficiencies and cost savings. (As for the 6% of companies that say they have no strategy for AI, probably best to avoid them with your investment dollars).

The second graphic here shows the expected profit margin expansion of 24 of the 25 industry groups of the S&P 500. 

  • There should be no surprise that Tech Hardware and Equipment sits at the top of the list. This industry group includes companies like Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), and IBM (NYSE: IBM) 
  • I’m surprised that Telecom ranks so highly. Companies like Verizon (NYSE: VZ), T-Mobile (NASDAQ: TMUS), AT&T (NYSE: T) and American Tower (NYSE: AMT). Please note that T-Mobile appeared on the list I published Monday of companies with the highest percentage of analyst “buy” ratings. Also note that American Tower acquired one of the biggest data center companies, Coresite, a couple years ago. Data centers will benefit from AI, hence my recommendation for Digital Realty Trust (NYSE: DLR) back in May
  • Semis – no surprise there. Nvidia (NASDAQ: NVDA) and AMD (NSYE:AMD), plus Taiwan Semi (NYSE: TSM) that makes the chips and ASML (NASDAQ: ASML) that makes the lithography machines that etch the circuits on the chips. 
  • Healthcare Equipment and Services is another surprise. The biggest Healthcare Equipment stocks on the S&P 500 are Merit Medical (NASDAQ: MMSI), AtriCure (NASDAQ: ATRC) and GE Healthcare (NASDAQ: GEHC). The potential for AI to improve screening for disease is potentially huge – from personal monitoring devices to reading MRI results. 
  • Autos might be another surprise, but it is already one of the most automated sectors in the S&P 500. The addition of AI for self-driving vehicles should be a boon for profit margins – when, and if, this technology becomes viable. 
  • Consumer durables, well, we’ve already had a pretty disappointing Internet of Things trend. Can AI do a better job? I’m skeptical of this one
  • And finally, financial services. Right now, the best AI plays are exclusive hedge funds, like Renaissance Capital and AQR. The romantic view is that firms like Blackrock and Fidelity turn AI loose on their finds and get better investment results. The reality is that  banks like Citi and Bank of America use AI to cut costs for things like automated customer service and fraud detection. 

Obviously there’s a lot more to talk about regarding which companies benefit the most from AI. And because the AI revolution is so young, there will no doubt be companies and specific applications that we’re not even aware of yet. 

Stay tuned to Pro Trader Today as we bring you the newest and best AI opportunities.

Take care and I’ll talk to you Friday…

Briton Ryle
Chief Investment Strategist
Pro Trader Today