How AI Works
For centuries, humans and machines have lived in harmony. Dating back to the development of the wheel which revolutionized farming and human mobility to the computers that landed the first human on the moon in 1969. The newest innovation in the technology sector that has sparked the attention of the public is artificial intelligence or AI. Simply stated, AI refers to the simulation or approximation of human intelligence in machines but, it’s also helpful to understand it in the context of an example.
Imagine yourself driving down the street in your neighborhood. What do you see? Most likely, there are other cars either parked or moving, children playing, pets or animals roaming around, and miscellaneous objects such as basketball hoops or trash cans. As humans, we are consciously or subconsciously analyzing our surroundings constantly taking stock of the potential situations that might arise. Due to our comprehension of societal values, we can order the importance of all objects on the road and take the necessary actions to maintain safety.
Prior to driving, humans have collected an unquantifiable amount of data points that specifically reference the value of all things, but AI doesn’t have that information. Humans can draw from their life experiences and contextualize the importance of people/things on the road. For example, at a young age humans learn it isn’t ok to hit other people but it is ok to bounce a basketball outside. Humans are alive therefore their safety is more important in comparison to a basketball.
They then can correlate that information with their knowledge of driving which provides them the ability to maintain safety to their best efforts. AI programs are attempting to correlate this data so that they can make these decisions correctly. In order to do so they must be supplied with large quantities of high-quality data so that the algorithm can train and improve. With more data and experiences the AI program will teach itself and take incremental steps in becoming a more effective driver.
How AI Has Impacted the Market
The market's current reaction to the developments and prospectus of AI has been overzealous at the least. In the short run, stocks are susceptible to emotional volatility and therefore deviate from a rational evaluation based on the company’s long term cash flows.
One organization that has experienced extreme fluctuations from the emotional movements in the market pertaining to AI is, Nvidia. Nvidia produces graphic processing units which are used in PCs, cars, robots, and now AI. Through their newfound association with AI, Nvidia's market value soured by 184 billion dollars on May 25th. This miraculous 24% gain moved their total market value to 938 billion just shy of joining the world’s one-trillion-dollar club.
Another company that has fared well for the market's overreaction to the new developments in AI technology is, C3.ai Inc. They boast negative earnings for the past four fiscal years but their stock price has jumped by 214% thus far in 2023.
Palantir is a software company that went public in 2020 and still has yet to report a profitable fiscal year. Despite that, its stock price still trades for about 15 dollars and has surged a total of 136% since the start of 2023.
Where AI may be worth the hype
McKinsey conducted a study with more than 400 use cases of machine and deep learning across 16 industries and nine business functions. With nearly all industries display clear benefits from AI programming. For instance, predictive maintenance, logistic optimization, and customer service are all business functions that could be enhanced through the assistance of AI. Aside from this study, generative AI has also proven itself to have numerous personal and professional utilization. Amongst the most common forms of generative AI is ChatGPT which can generate endless hours of content.
ChatGPT can be utilized to perform marketing, sales, operation, IT, engineering, risk, legal and R&D applications. The potential applications for AI seem almost unlimited but predictions rarely unravel perfectly.
Industries with large quantities of high-quality secure data can benefit the most from AI technology. E-commerce, Digital Advertising, Insurance, and other Data-heavy industries have the greatest potential benefit from the use of AI.
For instance, companies such as Netflix that collect and exclusively own huge amounts of behavioral data could integrate AI and gain a competitive edge. Understanding what people viewed, for how long, and at what time could help Netflix's advertisers better target their customers, Since Netflix exclusively owns all this data - it could be a source of a moat.
We believe access to large amounts of high-quality Data is the prerequisite for developing superior Artificial Intelligence.
Falls short of expectations
The usefulness of AI drastically decreases the larger the role random probability plays in a particular situation. For example sports, the 2023 eastern conference finals showcased the Miami Heat vs. the Boston Celtics. Before the series started ESPN gave the Heat a 3% of advancing to the finals. In game seven Jayson Tatum twisted his ankle in the first quarter and played horribly the rest of the game. Inevitably the Heat won and advanced to the NBA finals.
ESPN's sophisticated analytics couldn’t predict that the series would go to seven games and absolutely couldn't foresee Tatum's injury in a pivotal elimination game. Much like sports life is full of curveballs that can’t be predicted, even by AI. Wherever randomness is a major factor - past data becomes less and less important and so does A.I.
Additionally, from an investment standpoint, if AI is easily replicated by all, it wouldn’t create a significant difference in the competitive advantage one company has over the other in an industry. The company's intrinsic value would be derived from its future cash flows. The company has to either gain market share or improve its return on capital on assets to improve its long-term cash flows. This improvement would also have to be permanent for AI to affect stock prices meaningfully in the long run. Meaning just because you have good AI now doesn't mean that you deserve a better valuation.
Simply, Unless AI can drastically increase the future cash flows of an organization by either cutting costs or growing revenues(capturing market share) there won’t be any clear advantages to the firm for using AI.
Conclusion
As investors, we should be mindful and cautious of the hype surrounding AI especially when it comes to the evaluation of a business. For many companies, in a number of industries, AI has the potential to significantly improve productivity. However, just because a company uses A.I it doesn't mean that the company now deserves an astronomical valuation.
Ultimately for a company to be worth more it has to improve its long-term free cash flows. In cases where the adoption of A.I improve long-term competitive positioning or operating margins it's worth the hype, but in other cases, it's not. It's unlikely that the recent surge in AI stocks is warranted and investors should consider all that has been discussed thus far before they jump on board the AI train.
By:
Paul Gray; Chief Executive Officer
Siddharth Singhai; Chief Investment Officer
Disclaimer
This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This White Paper is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or a solicitation to buy any securities or related financial instruments in any jurisdiction.
Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Ironhold Capital Fund 1, L.P. (“Ironhold”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
