Rudi’s View: GenAi, The Super-Megatrend, Part 1

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GenAi, The Super-Megatrend, Part One

“In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.”
[Reid Hoffman, co-founder of LinkedIn]

By Rudi Filapek-Vandyck, Editor

Every experienced investor knows it pays dividends to be sceptical when all around us are getting excited.

We only have to look back in history to find plenty of examples of temporary share market excitements that had investors scrambling to get on board, only to find themselves on top of a sinking barge not long after. Remember 3-D printing? BNPL? Cannabis?

The commodities sector offers multiple examples just about every single year; from rare earths, to nickel, graphite, lithium, and coal companies… the swing from Zero to Hero to Zero status is usually swift and brutal, and it won’t be any different in the future.

None of these experiences negate the fact today’s world is changing on a regular basis and some of the changes occurring leave a significant imprint on businesses and society at large.

For investors, the importance comes through separating Winners from Losers, as the distinction will ultimately become irrefutable, either inside the investment portfolio or on the ASX, for all to see.

For some, investing will always revolve around picking up the pieces after disaster strikes. The share market has a habit of pushing excitement too far ahead of fundamentals, and disappointment too low into the abyss. So, there’s always a fresh investment case assuming things don’t get a lot worse.

For others, long-term investing is about tapping into growth, and enjoying the rewards of a multi-year uptrend. These investors know success is closely linked with ‘growth’. Growth pulls oxygen into the business and its share price. Without growth there are no long-lasting, sustainable rewards.

Over the past decade, investors looking for growth in the share market have gradually converged around the theme of Megatrends; societal changes that play out over extended periods of a decade or longer, creating Winners and Losers throughout the process.

For investors in growth, the importance seems obvious: better to own the Winners.

This doesn’t mean others can afford the luxury of ignoring what is happening at the macro-level.

A blueprint from the past

Back in the year 2000, News Corp ((NWS)) shares represented 13% of the ASX200. More than BHP Group’s ((BHP)) importance post abolition of the UK-listing. Today, News Corp draws most of its ‘value’ from the equity it still owns in online real estate portal REA Group ((REA)). Any moves in the share price are pretty much inconsequential for the index overall.

That pretty much sums it up for the local media sector generally. Online competitors REA Group, Car Group ((CAR)) and Seek ((SEK)) have only grown in size and importance over the past 24 years while their traditional brethren have shrunk and sunk deeper and deeper into the shadowy corners of the local bourse, where daily trading volumes evaporate and general investor interest dies.

Nine Entertainment ((NEC)), with a much deflated market cap of $2.2bn, is still part of the ASX100, but only until June 21st after which it will be relegated to the ASX200 and All-Ordinaries only.

In the world of institutional investors this means the once mighty Fairfax newspapers empire is about to become a ‘small cap’. No surprise, market rumour has it private equity is running the ruler over a business that combines old and new media, with no longer any ‘value’ incorporated for the print and radio media assets.

Southern Cross Media Group ((SXL)) is no longer in any index. Seven West Media ((SVW)) and ARN Media ((A1N)) can only be found in the All-Ordinaries. Others have disappeared. Sure, there have been times when any of these share prices went up, but one would find it hard to locate an investor who uses “great return” and any of these names inside the same sentence.

In contrast, WiseTech Global ((WTC)), which runs a digital service assisting companies with organising their complicated logistics, will be added to the ASX50 after the close of trading on June 21. WiseTech shares only listed on the local bourse on 11 April 2016, a little over eight years ago.

The past decade has seen multiple Megatrends being identified by investors, ranging from businesses and consumers going digital, to cloud computing and the emergence of a middle-class consumer in Asia. In the slipstream of these major changes, new businesses have been created; not all have been successful.

Those that did prove themselves as a true Winner have generated truly copious rewards for loyal shareholders. Examples include Altium ((ALU)), Audinate Group ((AD8)), and Xero ((XRO)), as well as the aforementioned WiseTech Global, REA Group, and Car Group.

Among the conclusions that can be drawn from past experiences, it is those tectonic shifts don’t move in a straight line, there will be interruptions and pauses; investors tend to become over-excited in the short term, while under-appreciating the potential further out; and there will always be plenty of ‘pretenders;’ and ‘wannabes’.

Eventually, the true Winners will rise above the pack, but their status may not always be as apparent from the get go.

GenAi: too good to be true?

So where does artificial intelligence, or more precisely generative Ai, its youngest technological breakthrough, stand against the background of all these past experiences?

It’s easy to open the traditional ‘value’ investors’ lexicon and roll out the criticisms: “investor exuberance”; “the next bubble”; “at these valuations and multiples, things will come crashing down next, just wait for it”.

On my observation, most of such declarations, and they are being made by many on a daily basis, are largely based on share price moves, without paying attention to the real growth that underpins these moves, or they come from the view there’s no lasting substance to this latest new technology. It’ll all burn out by the time investors realise GenAi is simply the next hula hoop.

Back in the 1960s, the Wham-O Toy company sold an estimated 25 million hula hoops in the first four months after launching its brand new toy, but that was the peak and most enthusiasts soon moved on to the next big thing.

The simplest counter-argument is GenAi offers businesses real, tangible benefits through either increased efficiency (higher margins translate into higher profits) or an additional source of revenues, or both. More precisely: GenAi offers the potential to obtain these benefits. No gain without first the pain. Any business aiming for future Ai benefits needs to make some sizable investments first.

Here’s where things really become concrete and real. These investments are being made. First in tens and hundreds of millions, accumulating into billions. Won’t be long before the numbers grow into trillions of dollars spent.

Sounds too good to be true?

Time to start paying attention to results releases and investor briefings by companies including Microsoft, Amazon, Alphabet and Equinix on Wall Street. They all are assuring us the investments made by governments and businesses around the world are real, they are significant, and they are only moving in one direction – up!

Mind you, all those investments come in addition to money spent by Big Tech, which is Big, really BIG.

Locally, the same insights can be gained from experiences and trading updates from first-hand beneficiaries such as Goodman Group ((GMG)) and NextDC ((NXT)). The first builds new data centres in partnership with or under contract for data centre operators. NextDC’s business is to own and operate data centres to facilitate the explosion in demand (not an exaggeration) for data storage and cloud computing power.

On current estimates, investment in Ai will reach US$200bn globally by next year. But things are moving so fast, these numbers are constantly revised upwards. Analysts at Morgan Stanley recently estimated additional investments made in new data centres in Australia alone will total between $21bn-$28bn over the next eight years. While stating these projections might well prove conservative, in practice this implies the local industry will at least double in size over that period.

Judging from these numbers, it looks like the industry’s biggest challenge is not a potential drop off in demand, but facilitating and servicing demand without delays, project failures, supply bottlenecks, and significant cost over-runs. And let there be no misunderstanding: the challenges are as tangible and real as is the surge in demand.

As one analyst from T Rowe Price explained during an online seminar recently: the latest graphics processing unit (GPU) from Nvidia requires (almost) as much power as your average US household. This implies the industry is adding the equivalent of a newly built Las Vegas every few months. Can anyone imagine the burden this represents for the country’s power grid?

Change happens in phases

The adoption and roll-out of new technologies proceeds through distinctive phases. Ai is no different. In the first phase, all the benefits (and attention) are reserved for what we can colloquially describe as the ‘picks and shovel’ providers; companies that deliver the hardware, the software, and anything else that is required to build the global infrastructure required.

Think semiconductor designers and manufacturers line Nvidia, TSMC and AMD, and their adjacencies. And data centre operators, including Amazon, Microsoft, and Equinix, and their adjacencies. As it has dawned upon investors Ai will require a whole lot extra in power generation, share prices in North-American utilities have equally enjoyed solid investor buying.

In Australia, the two most obvious beneficiaries have been identified in Goodman Group and NextDC. Both share prices are up more than 100% since the market’s low in October 2022 and are now trading on what most investors would regard as elevated multiples.

Upon deeper analysis, and assuming no major macro-economic or other disasters on the horizon, both companies are likely to enjoy very favourable growth dynamics in the years ahead, meaning their share prices, all else remaining equal, should appreciate to much higher levels. As per a recent modelling conducted by stockbroker Morgans, NextDC’s share price may well reach $40 in three years from today.

Even if that $40 projection proves too optimistic, with the shares rallying to a fresh all-time high last week above $18, the explicit message is there’s a lot more upside forthcoming. The outlook for shares in Goodman Group does not look fundamentally different. This will be one of the key challenges for investors who are not yet on board of these early-phase beneficiaries.

My personal view is such share prices will likely remain well-supported as long as the prospect for strong growth remains intact and believable.

Ai is offering Goodman Group a once-in-a-generation opportunity to generate super-profit margins, which accelerates its growth path, as the developer owns a sizable landbank that was build up to develop sophisticated warehouses and other industrial assets. Goodman is now able to tap into this resource on unprecedented demand for data centres.

On Friday, Citi analysts added Goodman Group shares to the broker’s Pan-Asia Focus List (essentially a selection of High Conviction Recommendations) while lifting the price target for the year ahead to a market-leading $40. Citi’s conviction relies on a forecast of double-digit annual growth for the medium term.

NextDC had already been adding extra capacity as the demand for data storage is a Megatrend in itself. The company has plenty of unallocated capacity, with more new data centres under development, implying lots of room to reap the benefits from the surge in demand.

Other companies are not by default in the same favourable position as Goodman Group and NextDC, but they will benefit too, and thus their share prices have equally been in demand. Additional beneficiaries include Macquarie Technology ((MAQ)), Global Data Centre Group ((GDC)), and Infratil ((IFT)), through data centre assets, as well as Megaport ((MP1)) and Southern Cross Electrical Engineering ((SXE)).

Macquarie Group ((MQG)) owns data centre operator AirTrunk, in which Global Data Centre Group holds a small equity stake too, and is currently shopping around for an eager buyer. Macquarie stands to make a multi-billion dollar profit from the sale.

It is not yet clear what the exact impact might be for listed utilities AGL Energy ((AGL)) and Origin Energy ((ORG)), and the same question mark applies for pipeline operator APA Group ((APA)). It is best not forgotten that if these facilitators need to make large investments first, any benefits will only come through (much) later.

I’d say the same logic should be adopted for telcos Telstra ((TLS)) and Chorus ((CNU)) for which GenAi represents both opportunity and threats (more on that shortly).

If strong demand for data centres means power prices will be permanently higher in the years to follow, one would be inclined to think AGL Energy and Origin Energy should be among the domestic beneficiaries.

From the latest industry insights released by analysts at RBC Capital:

-We believe data center supply should remain tight, amidst strong demand from cloud computing, generative Ai, social networking, software, and other verticals

-Energy-related and permitting constraints across many metros, coupled with long lead times on data center equipment and construction, are limiting the velocity at which new supply is coming online

-This in turn should drive continued favourable pricing and renewal spreads for those developers who are able to secure resources

-As energy transmission constraints are addressed, a process that can take up to several years, energy-related supply constraints could lessen over the medium to longer term

Part Two will be published on Thursday morning on the FNArena website.

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(This story was written on Monday, 17th June, 2024. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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