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QD view – AI mania driving tech recovery

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Big getting bigger

One of the dominant, and for most investment managers highly frustrating, trends of recent times has been the strength of the mega caps. It was really evident in the UK last year, where a handful of large stocks drove indices higher and, if you were underweight those, as most active managers would have tended to be, you underperformed. In the US market, the same phenomenon has been at work, with stocks like Microsoft, Apple and Nvidia driving the market higher.

In part, this has been helped by expectations of easing interest rates. While UK inflation has been quite stubborn, in the US and Europe, the headline rate has been falling sharply. The US Federal Reserve and the ECB may yet add 0.25–0.5% to their borrowing rates but the feeling is not much more than that.

However, AI mania, triggered by the unveiling of Chat GPT-4 by OpenAI in March 2023, has had a big influence on which stocks have soared.

Tech trusts benefitting

Very few managers have been able to capture the benefit of this within their portfolios, but some have succeeded. In the technology sector, Polar Capital Technology and Allianz Technology are up 13% and 16% in share price terms, respectively, over the past three months. Xuesong Zhao, one of the fund managers at Polar, published a (fairly technical) thought piece on AI on 7 June which you can read here. The conclusion of this was that the best way to play the growth of AI is through the semiconductor and semiconductor equipment industry. He highlights stocks such as NVIDIA, Advanced Micro Devices, Marvell, TSMC, KLA and Tokyo Electron – all of which are holdings in the trust.

Manchester & London is standout winner

If you look at the performance statistics in the global sector, unsurprisingly, Scottish Mortgage’s share price is a bit perkier (up 11% over a month but still down 1.5% over three months). However, the standout winner in the sector, and one of the best-performing of all funds over the past three months, is Manchester & London whose share price is up over 30%.

Manchester & London has a high conviction approach and has long been a believer in the AI story. In its latest factsheet, the managers reiterate their belief that the way to play the era of AI is through the “picks and shovels” providers and not through the AI application stocks. At the end of May, its five-largest positions were Microsoft (28.5%), Nvidia (12.9%), Advanced Micro Devices (9.1%), ASML (8.9%) and Cadence Design Systems (8.3%).

These are all large/mega cap businesses, the smallest of which is Cadence, with a market cap of about $60bn (in the UK it would rank as about the eleventh or twelfth-largest stock, about the same size as RELX).

Growth capital funds have exposure too

It feels as though almost every company is now thinking about the threats and opportunities presented by AI, some taking it more seriously than others. However, there are some growth capital funds with decent exposure to this area through unlisted investments.

Chrysalis and Edinburgh Worldwide hold what was hoped would be one of the leading ‘picks and shovels’ – Graphcore. It is making chips that have been specifically designed for the AI market (whereas market leader Nvidia sells chips that were originally designed for graphics in computer games). However, Graphcore is not yet making the inroads into this area that it feels its technology merits.

Other stocks in these and other similar funds tend to be more of the AI application stocks. Notwithstanding the comments above, it is possible that one or two of these could turn out to be winners. We’ve picked out four that we think show promise, but there are undoubtedly others.

One of the ones that has caught our imagination is Deep Instinct, a cybersecurity company that is using AI techniques to try to react faster to threats and even predict and block threats before they emerge. Chrysalis has a £71m stake in the fast-growing company. Deep Instinct recently secured the backing of PayPal Ventures and is winning awards and new customers.

Another company in Chrysalis’s stable is Featurespace. Its software is designed to use machine learning to prevent financial crime. It is used by banks, payments companies and the like to spot and block potential fraud.

Schroder Capital Global Innovation Trust (the former Woodford Patient Capital, now on its third name) has also been actively investing in the space. Having taken over as portfolio manager of the fund in 2019, Schroder’s first new investment was in Tessian, a cybersecurity company pioneering a new approach called Human Layer Security. It uses machine learning to stop security threats and data breaches by seeking to understand human communication patterns and behaviour, and looking for anomalous actions. It seems natural that cybersecurity will grow in tandem with AI investment, and Tessian appears to be at the forefront of protection against the increasingly complex risks that this will bring.

Another investment from the new manager is in healthcare company Ada. The company has developed a powerful, AI based health assessment and care navigation platform that helps users to understand their symptoms, and then source the right care. The opportunity for Ada is significant and, with over 13m users worldwide, the company has already been proven to reduce the burden on the drastically under resourced global healthcare system, while also providing healthcare to users that would be otherwise unable to access it.

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