Does the AI revolution justify today’s high ASX 200 valuation?

The S&P/ASX 200 Index (ASX: XJO) is down 1.37% on Friday at 8,435.6 points, which is 7.5% off the record high set last month.

Despite the drop, Blackwattle Investment Partners says the ASX 200 is still expensive.

The ASX 200 is trading on a 21x forward price-to-earnings (P/E) ratio compared to its 10-year average of about 16x.

Excitement over the artificial intelligence (AI) revolution has certainly helped drive up global markets this year, including the ASX 200.

Are we headed for bubble trouble?

Is AI a bubble?

At the time of writing, the market is down 2.3% this week due to worldwide concern over high technology valuations and continuing economic uncertainty, particularly in the US, where speculation on the next move with interest rates changes daily.

This uncertainty hit ASX 200 tech stocks hard this week, with the sector down 3.62%. Financials are also down 2.85% so far this week.

Some investors feel worried that the hype around AI is creating a bubble.

US tech stock valuations remain very high, and just a few companies comprise a very large portion of the S&P 500 Index (SP: .INX).

Investors are worried about how much money the big tech giants are spending on AI, and whether this investment will truly bear fruit.

Outside the tech sector, many businesses are investing in AI to raise productivity, but we’re yet to see this translate to earnings growth.

It’s simply too early in the AI revolution for productivity gains in non-tech businesses to show up in their financials.

AI revolution versus dot-com bust

Many analysts and investors have acute memories of the dot-com bust in the early 2000s.

The Nasdaq Composite Index (NASDAQ: .IXIC) crumbled 60% over two years after hitting its peak in March 2000.

That is a shivers-up-your-spine market collapse that no investor wants to risk going through again.

However, many analysts say things with AI are very different to the market dynamics that produced the dot-com crash.

They point out that the major US tech companies leading the AI revolution are well-established, well-run businesses, whereas many company failures during the dot-com bust were start-ups that did not effectively harness the internet to grow profitable businesses.

The US tech giants also have substantial cash reserves, which means they do not have to rely on debt to fund their massive AI investments.

The world’s largest investment asset manager, BlackRock says:

In our view, parallels to the dot-com bubble fall short: tech earnings quality and capital efficiency are stronger today…

And unlike the dot-com era, robust earnings support today’s mega-cap valuations.

This week, the latest quarterly report from AI chip giant Nvidia Corp (NASDAQ: NVDA) was seen as a litmus test for how the AI revolution is tracking.

A positive report would reassure the market, while a disappointing one would enhance fears of a bubble.

Here’s what happened.

Nvidia delivers record revenue

Investors’ nerves were settled after Nvidia announced another quarterly revenue record.

Nvidia achieved $57 billion in sales, up 62% on the prior corresponding period.

The company’s gross margin was a staggering 73.4%. Net income of $31.9 billion represented a 65% increase on last year.

Nvidia CEO Jensen Huang said:

The AI ecosystem is scaling fast — with more new foundation model makers, more AI start-ups, across more industries, and in more countries.

AI is going everywhere, doing everything, all at once.

Joe Koh and Elan Miller, portfolio managers of Blackwattle’s Large Cap Quality Fund, said their clients were constantly asking about AI.

In their latest update, the managers said:

Some commentators have suggested that the high valuation multiples seen in equity markets such as Australia’s can be justified by the emerging benefits of AI.

And speaking to the management teams of many listed companies, there is reason to be optimistic about the potential for AI efficiencies.

However, history would suggest that it’s not the extent of efficiencies that matter to shareholders, as much as the ability of companies to retain those benefits rather than passing them on to their customers.

Koh and Miller point to the airline industry as a case in point:

… despite huge advances in aviation technology over the last few decades, the returns of many airlines have been below their cost of capital.

The benefits essentially accrued to travellers in the form of lower airfares, rather than to shareholders…

The managers said higher-quality companies would likely benefit disproportionately from AI compared to poorer-quality businesses.

They explained:

… stronger market positions enable them to retain more of the benefits for shareholders, rather than passing it all on to customers; better data from superior systems, scale or history enable better AI training; and better capacity (financial or human) enables faster, smoother or more reliable AI implementation.

As always, quality wins out in the end (even if it has a rough month or two).

Eric Sheridan from Goldman Sachs Research does not think there’s an AI bubble.

He says the Magnificent 7 companies are still generating large free cash flows, conducting buybacks, and paying dividends.

The post Does the AI revolution justify today’s high ASX 200 valuation? appeared first on The Motley Fool Australia.

More reading

• Nvidia stock in an AI bubble? The AI giant’s fantastic Q3 results and guidance should put that concern to rest
• Bitcoin price collapse leads US$1 trillion crypto crash
• Why are ASX 200 tech stocks getting smashed on Friday?
• AI bubble worries are rising. Nvidia’s $31.9 billion profit says otherwise.
• Where will Nvidia stock be in 3 years?

Motley Fool contributor Bronwyn Allen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Goldman Sachs Group and Nvidia. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has recommended BlackRock. The Motley Fool Australia has recommended Nvidia. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.