Key Concepts
- AI Layered Approach: Viewing the AI investment landscape as a five-layer cake, from power generation to applications.
- SAS Apocalypse/Valentine's Day SAS: Significant drawdowns experienced by Software-as-a-Service (SaaS) companies.
- Moat Erosion: The potential for AI to diminish the competitive advantages (moats) of traditional software companies.
- Capex: Capital Expenditure – funds used by a company to acquire, upgrade, and maintain physical assets.
- MAG 7: The seven largest US technology companies (Microsoft, Apple, Nvidia, Amazon, Google/Alphabet, Tesla, and Meta).
- Beaten Raise: When a company reports earnings that exceed analyst expectations.
Market Volatility, AI Investment, and Broader Opportunities
The discussion centers around navigating market volatility, particularly within the AI investment space, and identifying potential opportunities beyond the heavily scrutinized AI trade. Whitney Stewart of Sterling Capital advocates for a layered approach to AI investing, drawing on an analogy presented by Nvidia CEO Jensen Huang.
The Five-Layer AI Cake
Stewart describes the AI opportunity as a “five-layer cake,” outlining the following layers:
- Power Generation: The foundational layer providing the energy required for AI operations.
- Chip Companies: Manufacturers of the semiconductors essential for AI processing (e.g., Nvidia).
- Data Center Companies: Providers of the infrastructure hosting AI workloads (e.g., Amazon, Microsoft, Google, Oracle, Meta).
- Model Companies: Developers of the AI models themselves (e.g., Anthropic, OpenAI, Google Gemini).
- Application Layer: Software application companies utilizing AI models. This layer is currently experiencing the most significant pressure and stock price declines.
Stewart argues that the most accessible and currently advantageous investment opportunities lie within the earlier layers (1-3), where identifying potential winners is comparatively easier. Layers 4 and 5 are considered more challenging due to increased competition and market uncertainty.
Concerns Regarding the Application Layer (Layer 5)
The market is demonstrating significant skepticism towards the application layer, with some referring to a “SAS apocalypse” or “Valentine’s Day SAS,” characterized by substantial stock price declines (25-50% in some cases over recent months). Investors are “shooting first and asking questions later,” reflecting a lack of confidence in the sustainability of valuations.
This downturn is fueled by the potential for AI to disrupt the software sector. The ability to create software at a lower cost using AI threatens the traditional “moat” of software companies – their recurring revenue, high growth, and high margins. Stewart notes, “If you can create software using AI at a much lower price point and you can create a lot of it for super cheap, the moat of those software companies may be eroded.”
Private companies like Anthropic and OpenAI are directly targeting the enterprise software market, aiming to generate $100 billion in annualized revenue by 2029 by capturing a portion of this existing profit pool.
Investment Focus: Data Centers and Chip Manufacturers
Stewart highlights the significant capital expenditure (capex) being invested by data center companies (Amazon, Microsoft, Google, Oracle, and Meta) – hundreds of billions of dollars annually – into AI infrastructure. This capital is flowing into the chip and power generation layers. She emphasizes that the current data center construction represents a doubling of existing square footage, driving demand for chips and power. Therefore, she favors investments in chip stocks and power companies.
Opportunities Beyond AI: Small Caps and Value Stocks
While acknowledging the AI opportunity, Stewart points to potential in areas less directly impacted by AI disruption. The “MAG 7” (Microsoft, Apple, Nvidia, Amazon, Google/Alphabet, Tesla, and Meta) has experienced a negative return year-to-date, while small-cap indexes have risen 7-9%, and value/dividend stocks have increased 8-10%.
These “old economy” companies, often more physical and less digital, are benefiting from lower expectations and cheaper valuations. Small caps, in particular, are experiencing “beaten raises” – exceeding lowered earnings expectations, leading to positive stock reactions.
Navigating the Small Cap Market
Stewart cautions that the small-cap market contains a significant proportion of unprofitable companies (approximately 40% with negative earnings). However, she believes a shift is occurring, with profitable companies beginning to outperform. She recommends focusing on small-cap companies with:
- Profits
- Strong balance sheets
- Consistent free cash flow
- High return on equity
Logical Connections
The conversation flows logically from a broad discussion of market volatility to a specific analysis of the AI investment landscape. The “five-layer cake” analogy provides a framework for understanding the different levels of risk and opportunity within AI. The discussion then expands to explore potential investments outside of AI, highlighting the relative attractiveness of small-cap and value stocks.
Notable Quote
“If you can create software using AI at a much lower price point and you can create a lot of it for super cheap, the moat of those software companies may be eroded.” – Whitney Stewart, Sterling Capital.
Conclusion
The key takeaway is the importance of a nuanced and layered approach to investing in the current market environment. While AI presents significant opportunities, investors should be mindful of the risks, particularly within the application layer. Diversification into less-disrupted sectors, such as small-cap and value stocks, may offer attractive alternatives. Focusing on quality – profitability, strong balance sheets, and consistent cash flow – is crucial for long-term success, especially within the small-cap market.
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