Billionaire Stan Druckenmiller is widely regarded as one of the greatest investors in American history. His hedge fund, Duquesne Capital Management, returned an average of 30% annually over three decades without a single down year. Druckenmiller closed the hedge fund in 2010 and he now manages his personal wealth through the Duquesne Family Office.
In the fourth quarter, Druckenmiller reduced his position in Nvidia stock by 29%, but he simultaneously purchased call options, contracts that give an investor the right to buy a stock at a specific price in the future. That strategy let Druckenmiller maintain exposure to the artificial intelligence (AI) chipmaker, while spending less money (call options cost less than the underlying stock) and taking less risk (call options do not have to be exercised).
With that in mind, it would be fair to say Druckenmiller was still bullish on Nvidia during the fourth quarter, but perhaps less bullish than in the third quarter. That is noteworthy for two reasons. First, Nvidia never traded about $505 per share in the fourth quarter, but the stock currently trades at a much pricier $762 per share. Second, Druckenmiller also redeployed some capital across other AI stocks: He added to his stake in Microsoft (MSFT 1.99%) and started a position in Arista Networks (ANET 5.22%).
To put those trades in context, as of the end of December, Druckenmiller had 12% of his portfolio allocated to Microsoft, 9.1% allocated to Nvidia stock, 7.2% allocated to Nvidia call options, and 1.6% allocated to Arista. Read on to learn more about Microsoft and Arista.
1. Microsoft
Microsoft is the largest enterprise software company in the world as measured by sales and market capitalization. It has a particularly strong presence in the business productivity and enterprise resource planning verticals due to its Microsoft 365 suite and Dynamics 365 suite, respectively. In total, the company accounted for 18% of commercial software spending last year, up 60 basis points (0.6 percentage points) from the prior year, according to Morgan Stanley.
Meanwhile, Microsoft Azure has been gaining share in cloud infrastructure and platform services (CIPS), due in part to strength in data management and cybersecurity solutions. The company accounted for 24% of CIPS spending in the fourth quarter, up nearly 200 basis points from the prior year, according to Synergy Research Group. Its strength in artificial intelligence (AI) and machine learning services also contributed to those share gains. Indeed, CEO Satya Nadella says Azure offers top performance for AI training and inference, as well as the best selection of machine learning models.
Market share gains across enterprise software and cloud services led to strong financial results in Q4. Revenue increased 18% to $62 billion, though 4 percentage points of that growth came from its acquisition of Activision Blizzard, and non-GAAP net income increased 26% to $2.93 per diluted share. Its revenue growth may decelerate modestly, but the company still has favorable tailwinds.
Specifically, Microsoft has positioned itself to be a major beneficiary from the growing use of AI systems. It is OpenAI's largest investor and its exclusive cloud provider. Their partnership means Microsoft monetizes usage of ChatGPT and other OpenAI applications, and it allows Azure customers to build custom generative AI applications using OpenAI's large language models. JPMorgan Chase analysts have said Microsoft's investments in OpenAI could be some of the "best money ever spent."
Microsoft is also monetizing generative AI with Microsoft 365 Copilot, a conversational assistant that can draft text in Word, create slides in PowerPoint, and organize data in Excel. Additionally, the company is adding generative AI capabilities to its enterprise resource planning software to automate tasks across sales, service, and finance. Those products could result in large revenue streams in the future, given that Bloomberg Intelligence forecasts that generative AI software market will grow by 6,260% between 2023 and 2032.
Wall Street analysts expect Microsoft to grow its earnings per share at an annualized rate of 14.9% over the next five years, but that consensus estimate may underestimate the impact of AI. I think Microsoft could grow 1 or 2 percentage points faster. Even so, its current valuation of 36 times earnings looks a little pricey, especially when the three-year average is 32.4 times earnings. Personally, I would feel more comfortable buying shares if the price-to-earnings ratio was closer to 30. So, while the stock is currently 7% off its high, investors should wait for a bigger pullback before buying a significant position.
2. Arista Networks
Arista is a pioneer and market leader in cloud networking solutions. Its switching and routing platforms interconnect compute and storage within high-speed data centers across public, private, and hybrid environments. Fast switches are vital for running demanding workloads like AI applications. Arista also offers adjacent software for network automation, analytics, monitoring, and security.
Management says its principle invention is the Extensible Operating System, the software that powers every Arista platform. That approach differentiates the company from legacy vendors like Cisco Systems that use multiple operating systems, which makes network management more complicated and costly. Arista has also differentiated itself by incorporating third-party silicon into its switches rather than designing its own chips, a strategy that allows the company to focus its R&D budget on keeping the Extensible Operating System software ahead of the curve.
Cisco is still the leader in the market for data center switches, but Arista has been gaining ground for over a decade, such that the market share gap narrowed from 69% in 2013 to 4% in 2023. More importantly, Arista dominates the market for high-speed data center switches, meaning platforms that offer throughput of 100G (gigabits per second), 200G, and 400G. The company captured 45% of that market last year, up 400 basis points from the prior year, while runner-up Cisco captured a 20% share.
Arista reported solid financial results in the fourth quarter. Revenue rose 21% to $1.5 billion and non-GAAP net income jumped 48% to $2.08 per diluted share. On the earnings call, CEO Jayshree Ullal told analysts, "We outpaced the industry in quality, support, and innovation."
Secular trends like cloud computing and artificial intelligence should boost demand for faster networking solutions, and Arista is better positioned to benefit than any other company, according to Morgan Stanley. Even so, Arista just had particularly good year and the cyclical nature of hardware sales suggests its revenue growth will almost certainly slow in the near term.
Wall Street analysts expect Arista to grow sales by 12% annually over the next five years. That consensus estimate makes its current valuation of 13.3 time sales look pricey, especially when the three-year average is 11.6 times sales. Personally, I would feel more comfortable buying the stock at a valuation closer to that three-year average. So, even though the stock has fallen 20% from its high, I would wait for a bigger pullback before buying a significant position.
