Recent advances in artificial intelligence (AI) have dominated news headlines and global equity markets. Businesses around the world are embracing the opportunities AI can bring to their operations. The companies that have developed this technology are continuing to spend enormous amounts of money on research and computing infrastructure. It is a technology that looks set to affect nearly every aspect of our lives.
However, we aim to look beyond the headline-grabbing market leaders in the technology sector in search of companies that will prosper, irrespective of which AI technologies secure market-leading positions. At McInroy & Wood, our investment team identify, research, and monitor every company in our clients’ portfolios, which gives us complete control over their exposure to different themes, countries, and risks.
The development of AI is as fundamental as the creation of the microprocessor, the personal computer, the Internet, and the mobile phone. It will change the way people work, learn, travel, get health care, and communicate with each other.
Bill Gates
The spectacular returns from investment in companies in the global technology sector have been based on their exceptional growth of profits. Over the past 15 years, they have increased earnings fourfold, while other areas of the market have grown theirs by a relatively modest 25%. The resulting share price appreciation of the sector has contributed a third of all global equity returns since 2010.
Microsoft is one of the companies that have dominated equity markets. We hold this in client portfolios because of the company’s ability to harness its market-leading positions to deliver attractive sales and profit growth. People all over the world use its Office365 software suite and are generally reluctant to switch to an alternative. It is also one of the global leaders in cloud computing, whereby computing services like storage, databases, software, and analytics are delivered over the Internet. You may have received this note via Microsoft Outlook, which uses Microsoft Azure’s cloud services. While we remain confident about the company’s long-term prospects, we also recognise the importance of continually challenging this assumption to ensure that we maintain an objective, balanced view.
As a result of the notable gains made by a small number of very large companies, the US stock market has reached a concentration last seen in the mid-70s. Such an exceptional period is unlikely to last. Historically, investors eventually become nervous about the sustainability of profit growth in expensive stocks and switch to a much wider range of companies. Once this shift has happened, it often takes many years for the former market darlings to return to favour, if they do so at all.
Technology investors frequently project explosive growth rates far into the future. Yet history shows that technological breakthroughs tend to be led by new entrants, even in markets dominated by firms with large research and development budgets. Many of us will remember how Apple’s introduction of the iPhone overwhelmed Nokia, Motorola, and even Blackberry. The mobile phone market is also a good example of how investors can become swept up in the hype around the first wave of new products, overestimating their immediate impact while underestimating how a later development building on their technology can go on to lead the market. Internet-enabled smartphones have been much more transformative than early commercial mobile phones, the first of which allowed only 30 minutes of conversation in return for a ten-hour charge. Likewise, dial-up internet required remarkable patience. Web pages clunked through in stages. It truly came to life with the revolutionary impact of broadband, wi-fi and, particularly for mobile phones, 3G networks.
Rather than investing directly in companies selling AI applications, we focus on specialist businesses that supply them with the technology and services needed to develop AI applications and their connected infrastructure.
One example is ASML. It is the leading manufacturer of photolithography equipment used to produce microchips. The company holds a monopoly position in the most advanced products in the area, which involves projecting extreme ultraviolet light onto silicon wafers. This allows intricate microscopic patterns to be printed before they are turned into electronic circuits in subsequent steps of the chipmaking process. Packing ever more electronic circuits onto each microchip, referred to in the industry as "shrink", is the key to improving its performance and efficiency.
Although such advanced technology is expensive – ASML’s machines each cost hundreds of millions of dollars – it is in considerable demand. The company is a critical supplier to all computer chip manufacturers, including TSMC, the Taiwanese company that makes the AI chips designed by headline-grabbing NVIDIA. ASML is one of the few companies in the world that can claim to have an irreplaceable role in the progress of AI, and it looks set to prosper irrespective of whose technology, or large language model, becomes most popular.
While companies like ASML are themselves not immune to stock market fluctuations, we believe this approach of emphasising suppliers rather than end-users should mitigate some of the volatility of share prices in the technology sector while delivering sustainable returns over the long term.
In a broader sense, we seek to identify and invest in companies that harness cutting-edge technology to give their businesses competitive advantages. It is a longstanding approach. When we launched the McInroy & Wood Balanced Fund in 1990, one of our first and most successful investments was Dionex, a US specialist in analytical chromatography machines that used innovative product development and state-of-the-art software to differentiate itself from competitors. The company produced exceptional returns and remained in the portfolio until it was acquired by a competitor in 2011.
Dionex shows how the imaginative use of technology can improve products and services and enable businesses to operate more efficiently. As a result, companies that apply, rather than create, technological advances are likely to achieve greater profitability in the long term.
Uber was impossible without the smartphone, which itself was enabled by GPS, which was enabled by satellites, which were enabled by rockets, which were enabled by combustion techniques, which were enabled by language and fire.
Mustafa Suleyman, CEO of Microsoft AI and former Head of Applied AI at DeepMind
Similarly, we bought the Swiss hearing aid manufacturer Sonova for portfolios some 20 years ago, attracted by the company’s innovative culture. Since then, it has incorporated several new technological developments into its products, including advanced microchips to improve sound processing quality, Bluetooth to extend connectivity and 3D printing to provide custom fitting. This application of technology to create tailored hearing solutions has enabled the business to evolve and grow.
Companies like these are even more interesting to us if they are lesser-known and under-researched, such as Tokyo Ohka Kogyo, a Japanese supplier of chemicals critical to the chipmaking process.
While our limited exposure to the biggest companies in the US technology sector might, on the face of it, suggest an absence of cutting-edge stocks in client portfolios, we prefer to survey a broader range of long-term opportunities. We are invested in leading businesses that are highly successful in the application of technology rather than simply its creation. These are fascinating, high-quality companies that operate, to some degree, out of the limelight. In time, we believe investing in them will deliver exceptional rewards as others begin to appreciate their enduring attractions.
This approach also allows us to maintain a level of diversification essential to managing risk in portfolios rather than being exposed to a few very large positions in fashionable stocks.
While our limited exposure to the headline-grabbing companies might suggest an absence of cutting-edge technology stocks, we prefer to survey a broader horizon of long-term opportunities.
Equity market returns have been narrowly concentrated in recent years. But the unpredictability of market timing highlights the need for a disciplined investment approach and a diversified portfolio of global companies.
Searching for soundly financed businesses with strong competitive positions has been fundamental to our investment approach since 1986 and has contributed to our long-term performance.
