Artificial Intelligence Revisited

One year ago, we wrote a market commentary called “The Dawn of Artificial Intelligence.” In it, we discussed the emergence of artificial intelligence into mainstream awareness and our approach to investing amidst this amazing technological development. Today, AI remains top of mind for investors, and the hype surrounding it has only become more extreme.

The evolution of AI is still in its early stages with a few large technology companies squarely at its epicenter. These technology behemoths are spending massive amounts of money to build new data centers that enable the use of this new technology. A gold rush, of sorts, is occurring between a relatively small number of large companies trying to establish themselves as the singular AI leader.

In the stock market, these few large tech companies are the focus of investors’ excitement, and in the first half of the year they accounted for a majority of the S&P 500’s return. In fact, the seven largest tech companies (the “Magnificent Seven”) accounted for approximately 60% of the year-to-date return of the S&P 500 index, outpacing much of the rest of corporate America’s returns.

Aside from these few companies developing AI, most other businesses are exploring ways to deploy AI technology in their day-to-day operations. The hope is that AI will boost employee productivity and make business operations more efficient.

We remain strong in our belief that it is way too early to know with certainty which companies and industries will benefit most from AI and which will be left behind. It is important to keep in mind that what looks like a certainty today may look less so as this technology evolves. Long-term winners and losers will be determined over a period of many years, and there are no guaranteed winners when a major technological shift like this occurs.

Don’t Get Too Caught Up In The Moment

As we look back over the developments of the past year, we believe it is important to avoid getting too caught up in this exciting AI moment. Instead, we should zoom out and view recent developments from a longer-term perspective. In what has been called “Gates’ Law,” Microsoft founder Bill Gates stated that, “we tend to overestimate the impact of technology in the short-term and underestimate the effect in the long run.” Gates’ Law certainly held true in the late 1990s with the development of the internet, when excessive investor enthusiasm created the dot-com bubble in the stock market. In that instance, investor exuberance proved to be premature, and that bubble burst as it took years for the internet to fully develop. But in the long run, the internet proved to be a transformative technology that even the most optimistic pundits underestimated.

Throughout history, there are numerous examples of technological developments that went through a hype cycle when short-term excitement got ahead of itself. In recent years, investors got very excited about the prospect of electric vehicles (EV) rapidly replacing internal combustion engine vehicles as part of the energy transition. Stock market valuations for EV manufacturers were initially very optimistic and, in some cases, speculative. Today, that initial hype has died down, valuations have declined and some of the more aggressive companies have gone out of business. Society’s move to EVs is continuing but the pace has slowed, and the early excessive excitement ultimately proved too optimistic. While this doesn’t tell us what will happen with AI, we think it is important to keep these lessons in mind as we approach investing today.

As we look back over the developments of the past year, we believe it is important to avoid getting too caught up in this exciting AI moment.

Maintaining Our Discipline

Businesses are typically valued based on estimates of their future cash flows. During a new and profound technological change, investors have a difficult time accurately calculating appropriate valuations for businesses directly impacted by that change because future cash flows are difficult to estimate. Amid these technological revolutions, it is easy to understand why some businesses can be valued with excessive optimism or pessimism, resulting in stock prices that can be quite volatile. Reality will eventually reveal itself, but actual long-term cash flows may turn out to be quite different than today’s optimistic estimates. Therefore, it is especially important to remain disciplined in establishing our estimates of business valuation. Paying reasonable and rational prices is a critical part of controlling risk in your portfolios and a foundational principle in our investment strategy.

Many Other Investment Opportunities

Even though it feels like today’s AI-related companies are generating most of the near-term stock market returns while dominating the business news cycle, there are plenty of other attractive businesses outside of AI and the technology industry. And with so much enthusiasm focused narrowly on the developers of AI, the valuations of many outstanding companies in other industries are much more reasonable than some of the extremely optimistic valuations of AI-related companies.

We find the potential for AI exciting, but our investment process is sector-agnostic. In our search for new investments for your portfolios, we seek companies that have understandable and sustainable advantages over their competition. The intelligent utilization of AI may serve to enhance many business models, and the application of AI will occur across many companies in a variety of industries. We are on the lookout for these developments. But at the end of the day, we simply look for terrific businesses run by talented, honest management teams that are trading at a compelling price. Each investment we make must meet all three of these strict criteria.

Over the next decade, we expect excellent returns will be available from a number of different companies across many industries – and not just the developers of AI. Similar to the success of companies who best harnessed the power of the internet in past years, the companies who utilize AI best in the future are likely to achieve great success. We will be searching diligently in the coming months and years to add more of those companies to your portfolios to help build your wealth responsibly for years to come.

Baird Trust Company (“Baird Trust”), a Kentucky state- chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), (an SEC-registered broker dealer and investment advisor), and other operating businesses owned by BFC. Past performance is not a predictor of future success. All investing involves the risk of loss and any security may decline in value. This is not intended as a recommendation to buy any security and views expressed may change without notice. Baird Trust does not provide tax or legal advice. This market commentary is not meant to be advice for all investors. Please consult with your Baird Financial Advisor about your own specific financial situation.

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