4 steps to identify AI winners (and 10 stock examples)

If you’re looking for growth, it’s hard to go past the tech sector. After all, some of the greatest life-changing innovations of our times occur there and propel the companies fuelling these to the highest of heights.

Each cycle of tech innovation has its winners and losers – just think back to the dot-com crash as an example. So far, the Magnificent Seven appear to be the latest winners in the AI-boom, but are they the only options and how do you manage the risks of investing in new tech like AI when you don’t know whether it will stand the test of time yet?

In the latest episode of The Rules of Investing, Livewire’s Ally Selby discussed this challenge with T. Rowe Price’s Dom Rizzo and he shared why he believes AI will stand the test of time, how he identifies winners and stocks he likes.

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Why AI will stand the test of time

Rizzo is bullish on the prospects of AI.

“I believe AI has the potential to be the biggest productivity enhancing technology for the global economy since electricity,” he says.

He explains that this comes down to two things.

1. The rise of parallel computing i.e. graphics processing units (GPUs) which allows for much faster dealing with big data issues.

2. The rise of large language models (LLMs) in software which gives data context and can be applied to all different areas of the economy, such as code writing, cybersecurity, simulation.

As with any other innovation, bubbles can appear – as we saw with the internet – and stocks can rise on hype.

“Really think about which companies truly benefit from AI, and which ones are the imposters,” Rizzo says, pointing out that Nvidia is a true beneficiary and AMD could be a nice second source.

The framework for identifying AI winners

Rizzo believes in having a framework to match your personality – he likes innovation and change so the framework has to meet these goals. He looks for four things across the tech sector.

1. Linchpin technologies

“These are the most mission critical technologies for the success of their customers, or they make their users’ lives dramatically better,” Rizzo says.

2. Innovation in secular growth markets

3. Improving fundaments in the form of three options.

“Either revenue that is accelerating so growing faster than it used to, operating margins that are expanding or free cashflow conversion that is improving,” he says.

4. A reasonable valuation

Rizzo cautions that it’s rare to find a stock that matches all parts of the framework exactly so you have to make considered choices. In fact, one of the rare times a stock has perfectly met all of the components was Nvidia (NASDAQ: NVDA) in December 2022.

Managing the risks of investing in innovation

Investing in change understandably comes with risks. After all, you don’t always know if a form of innovative technology will ‘take off’ or not. Alongside his framework, Rizzo seeks to manage these concerns with what he terms as a ‘go-anywhere strategy’.

He invests across small, mid and large-caps, across regions and across technology formats – hardware, software, internet, payments. The key is a balance between slower growth options and potentially riskier options.

“You can have more ballasting names in the strategy, like Apple or Microsoft, which provide a more durable growth profile,” he explains, highlighting that this allows you to also incorporate potentially riskier fast-growing options like Shopify (NASDAQ: SHOP), Datadog (NASDAQ: DDOG) or Confluent (NASDAQ: CFLT).

“It’s about putting together a bunch of idiosyncratic names that hopefully move together differently and can try to blunt that downside a bit and then try to capture the upside.”

The stocks worth paying up for

Rizzo has a 43% exposure to semiconductor stocks in the portfolio – but is a big believer in this theme. He argues that not all semi-conductors are the same and they operate off different cycles, ranging across:

• Analogue semiconductors like Texas Instruments (NYSE: TXN) and STMicroelectronics (EPA: STMPA) which sell into the auto and industrial markets.
• Digital and commodity chip like Micron (NASDAQ: MU), Samsung (KRX: 005930) or SK Hynix (KRX: 000660).
• More differentiated chips – GPUs such as sold by the likes of Nvidia or AMD (NASDAQ: AMD).
• Semiconductor equipment – companies that make the tools for chips; and
• Foundries like Taiwan Semiconductor Manufacturing Company (TPE: 2330).

While valuations for companies in this theme can be at a premium, Rizzo highlights a few he believes are worth paying up for: AMD and Taiwan Semiconductors.

Rizzo notes these will access continued (though decelerating) growth in AI while maintaining traditional exposures through supply to expensive and attractive software names. He also remains bullish on Nvidia, noting that the AI chip market is expected to grow from $45 billion in 2023 to $400 billion by 2027 and Nvidia is the clear leader in the AI-space.

Moving to heavier valuations in software names, Rizzo likes IT service management leader ServiceNow (NASDAQ: NOW), which has become “the platform of platforms” and is increasingly putting AI into its ticketing tool.

The biggest linchpin

The one stock that Rizzo believes is the ultimate linchpin is ASML (NASDAQ: ASML) in the Netherlands – the leader in lithography which is one of the most important steps in semiconductor manufacturing.

“They are the only company in the world that has this incredible extreme ultraviolet lithography technology and their next generation, the High NA technology, then the following generation, the Hyper NA technology,” Rizzo says, noting they have been critical in offering tools to make thinner chips and ongoing improvements to node technology.

No flash in the pan

It's clear AI is here to stay and Rizzo is bullish on semiconductor theme underlying it. Have you invested in any of the companies he likes? Let us know your picks in the comments.