Carolyn Bigda: Welcome to this special series of Research in Action, where we provide a quick take on the outlook for the major economic sectors and the investment implications for 2024. We’re your hosts, Carolyn Bigda…

Matt Peron: …I’m Matt Peron, Director of Research.

Bigda: And in this episode, we’re joined by Denny Fish and Jon Cofsky. Both are Portfolio Managers and Co-Leads on the Denver-based [Tech] Sector Team here. And today, they’re going to talk about AI and all the other things that investors should be paying attention to in the tech sector for 2024. So, Denny and Jon, thanks so much for joining us.

Denny Fish: Yes, absolutely. Happy to be here.

Jon Cofsky: Thank you.

Bigda: So, we wanted to start out with the big story of 2023, which was AI. That technology basically hit an inflection point, where the world stood up and took notice, and said, okay, there’s something pretty unique here, something that’s a little bit game-changing. And I was wondering, for 2024, is the momentum around AI expected to continue? And what does that mean for the tech stocks that had benefited quite a bit from this new trend, or this new technology?

Fish: Absolutely, I think you characterized it the right way, that the world woke up to AI. It’s something that we’ve been researching for several years, it’s been one of our mega themes. And while it was a mega theme behind the scenes, there wasn’t that moment, until ChatGPT hit, and then the world actually saw, in a very practical way, what was possible. And then we’ve seen multiple iterations of that product, competitors from Google and Anthropic and others. Google has just launched Gemini, which is a multimodal AI engine, as well.

And so, it’s a long way of saying that it’s very, very real. There’s an old adage in technology that we always overestimate what’s going to happen in a year, and we underestimate what’s going to happen in a decade. And I feel like that’s what ‘24 is what we’re set up for. Because there’s so much excitement around the promise of AI, now we have to start delivering on that promise. And you’ve seen all of the hyper scalers invest massively in capital expenditures to support AI, the training of the models. And now we have to actually see the use cases come through, the monetization, the real-world build-up of the financial models of these companies. And this is where we’ll start to separate – not the rising tide lifts all boats because there’s an AI halo, but the companies that are truly benefiting from AI.

Bigda: Right, because in 2023, investors got really excited about the potential, and we saw that reflected in a lot of technology stocks. Now we have to see it come to fruition, correct? We need to see the actual application of that promise, at this point.

Fish: Yes, and it’s going to touch every sector of technology, and it’s going to touch every sector of the economy – and that’s what’s important. And it won’t be as obvious for all the other sectors of the economy, but there’s going to be a lot going on under the surface as it relates to AI and how companies are broadly deploying it.

Peron: So, zooming out to the tech sector in general. Rates became an issue, especially in 2022, and put pressure on valuations, and that really became a key issue that tech investors had to grapple with. Now that we’re through a lot of that, where are we settling out? How are you guys thinking about the rate impact on the sector?

Cofsky: The 2020-2022 time period was so unusual with rates at zero and then inflation and rates rising more rapidly than they have in decades, that we’re trying to go back to, say, the 2015-2019 period where we had a more “normal” rate and inflation environment.

But importantly, throughout the whole time period, our focus on fundamentals and unit economics and free cash flow haven’t changed. We don’t predict interest rates, but our focus on fundamentals and unit economics and what are the growth areas of the economy that are exposed to trends like cloud [computing] and AI, that won’t change.

What may also be helpful for tech, if you think rates are potentially stabilizing or going down, especially as inflation goes down and the economy cools, growth becomes more scarce. And where’s there the most growth in the economy? It’s in tech. So, tech could actually benefit in an environment like that.

Fish: And if I could add one other thing, too, as it relates to rates – one thing that we never did as a team was start moving our discount rate all over the place. We actually stayed pretty consistent with our discount rate throughout this time period, and I think that was helpful, in terms of managing our valuation discipline.

Peron: That’s a key point, isn’t it? The fact that your long-term rate – we’re really back to where we were – and the long-term rate impact is, generally, through the cycle has not changed.

Fish: Yes, exactly.

Bigda: Okay. So, let’s take that, and maybe talk about potential areas of tech that have flown under the radar, where maybe the market is overlooking it because of the excitement around AI, worries about interest rates. Are there any areas of tech that have gone under the radar?

Fish: I don’t know if areas of tech have necessarily gone under the radar. I think the ones that have gone under the radar have gone under the radar for the wrong reasons. But I think an area of the market, despite the stock performance over the last year that is still fundamentally underappreciated is semiconductors and semiconductor capital equipment. In my opinion, it is the most important industry to global economic growth. It’s more important than anything else. We cannot advance society without semiconductors and semiconductor capital equipment. And it’s a very rationalized industry as you start looking across it, with secular growth that is about 1.5x to 2x GDP [gross domestic product] growth; margins that are much higher than the average company in the S&P 500^® [Index]; and great capital allocators.

And the kicker is that every continent in the world and many countries want their own sovereign footprint for semiconductor development; whether it’s China; whether it’s Europe; whether it’s Japan, India, the United States, as we’ve seen with the CHIPS Act. And this is a 20-year journey that we’re just starting right now.

Peron: Semiconductor equipment is oligopolistic, is it not? So, to your point about being rational, it’s something where there’s a few innovators in that space.

Fish: Absolutely, it’s really interesting because there are many companies that actually participate in the semiconductor capital equipment supply chain, but there are really five companies that dominate the space. And it’s interesting because one is a natural monopoly, ASML, with what’s called EUV lithography. Nobody else on the planet does it. It’s rare you find a monopoly just like that.

And then the other four are actually what we call narrow monopolies. If you were doing a Venn diagram, they all compete with each other. But for the most part, they run in pretty healthy swim lanes, where they don’t face a lot of competition. And so, to your point, you have these oligopolies within these swim lanes. And then there are also other areas, too: EDA [electronic design automation] software, that’s a duopoly.

And then the important thing about the semiconductor industry itself is that it went through so much consolidation over a 20-year period that the end markets for semiconductor capital equipment are also highly rationalized, as well. So, you’ve seen much better pricing power, less pronounced inventory cycles, and just all around a more efficient industry structure with these natural secular tailwinds that allows it to grow faster than the global economy.

Cofsky: And you also have analog chips in some of these $2 or $5 parts that make your EV [electric vehicle] or your factory automation system work. And they’ve been hurt more by the economy. And maybe they’re not as direct a beneficiary from AI, but they are a beneficiary. And something like electronic vehicles, or electric vehicles, that are going to be a 10-, 15-, 20-year trend, and we’re still very early in the U.S. The semi content in those vehicles are significantly higher.

Peron: Back to Carolyn’s question, that’s some under-the-radar stuff. You don’t hear too much about EUV [extreme ultraviolet lithography] or EDA or things like that. But your team has really been on these as secular growers that have a long runway in front of them.

Fish: And it’s also a sector where the stock prices tend to be a bit more volatile than the actual underlying resilience of the business, and that’s what’s great. It gives us opportunities to pick away at things when the market gives us our chance.

Peron: I don’t think you hear about it in the newspapers so much because lithography is not exactly something that gets the headlines.

Fish: Totally, but you know what, it is like rocket science. I was just over in the Netherlands at ASML a couple of weeks ago, and you go over there and you’re just reminded of how hard this is. These machines, just to put it into context for people: When TSMC or Intel buys an EUV machine from ASML, it takes one or two 777 jets to get all of the parts for the EUV machine over to Taiwan or the United States to be reassembled.

Cofsky: And isn’t it a few 100,000 parts to make it?

Fish: Yes.

Bigda: It’s pretty incredible. But to your point earlier, I think what is in the headlines is the volatility around semiconductor stocks and that might turn off some investors. And so, do you see that smoothing out over time, with the rationalization, with the long-term secular trends? Or do you think it’s still an area of the sector that could be a little bit more volatile from an investing perspective?

Fish: Well, it’s always a tough question to answer. I do think, if anything, what COVID awoke the world to was the importance of semiconductors. There was almost a two-year period you couldn’t get a car, you couldn’t get a washing machine. And it could have been because of a CPU [central processing unit] or GPU [graphics processing unit], or it could have been an 80-cent part from Texas Instruments that was just managing voltage, or something else, who knows?

But that, in itself – every industrial analyst on the planet is, like, wow, all my companies are talking about they can’t ship product because they can’t get semiconductors. Every auto manufacturer, everything. And so, I think that woke up the world. And so, I think there’s the possibility that you end up with structurally higher multiples and maybe less volatility and more confidence to look through to the other side because of the durability of the industry structure.

But the reality is, we’ll see. The stock market overrates things on the upside a lot, and they overrate things on the downside a lot. And so, we have to be really conscious of that, too.

Peron: And I think it’s fair to say that semi-cap equipment is less volatile because of its long sales cycle and all of that than semiconductors themselves.

Fish: Yes, in some areas, and then some areas not so. It just depends. But I always ask people this question, and this is just rough ballpark, but if I asked the average investor, what’s been a better stock over the last 10 years? A basket of those five semiconductor capital equipment companies and the EDA companies, or Alphabet? And almost invariably everyone’s saying, well, it’s got to be Alphabet. It’s not.

Cofsky: There are some of the best software companies benefiting from cloud, internet companies and those businesses. Even if the stocks can sometimes be volatile, those businesses tend to be highly recurring, so that provides a little bit of an offset to semiconductors, which are a cyclical growth industry, but still cyclical.

Bigda: So, you’ve provided the perfect segue way to my last and final question, which is just looking at maybe some other long-term themes in the tech sector, things like cloud computing, 5G. Where are those now in their evolution? And what milestones might they be hitting in 2024 that could be important for the sector?

Cofsky: So, it’s interesting because we’ve been talking about cloud and even mobile for basically a decade, or a bit more than a decade now. But if you look at the amount of IT spend or workloads, it’s still under 50% in aggregate in the cloud. So, we think there’s still many more years of good growth from cloud, which is hard to fathom given we’ve been in this growth trend for so long. But we think there’s more to come there. And generative AI is also, you need to be in the cloud for the most part to take advantage of generative AI. So, that’s really going to pull even more workloads to the cloud.

5G is a bit different, because we’ve had the rollout of capacity and now you need the killer app to densify the capacity, and there’s the hope that maybe generative AI could be that killer app.

Fish: Yes, and what I would add is exactly that. 5G has been a mega theme for the last, call it six or seven years. We’re plateauing out. We are 50% penetrated globally or something roughly, and now, it’s just that incremental transition to 5G. So, in some ways, the whole telecom spectrum thing is pretty uninteresting right now. And it won’t be ‘til we get closer to 2030, when we start talking about 6G, where, that’s where we’re going to have some real, significant fundamental change because of the improvements in speed and near-zero latency, which is going to enable a lot of these amazing at-the-edge use cases associated with AR [augmented reality]/VR [virtual reality], autonomous driving. I was just in Scottsdale, [Arizona] at a conference, and I loved taking the autonomous Waymos around, it was great. It was such a good experience. And we still have a long way to go, but for that constrained use case, it’s pretty amazing. But we’re going to need 6G networks to be able to do it.

Bigda: I’m glad to hear it was a good experience. I think you have to be a little brave to get into one of those cars at this point.

Denny and Jon, thanks so much for joining us. We really appreciate getting your insights on tech for 2024.

Cofsky: Thank you.

Fish: Absolutely, thanks.

The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow analysis.

S&P 500^® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.

Free cash flow (FCF) yield is a financial ratio that measures how much cash flow a company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.