In the sport of long-distance running, there is something called a corral start. The idea is to group people with similar paces so that the beginning of the race is less congested.
With the artificial intelligence (AI) arms race underway, it seems like just about every name in the tech sector is looking to participate. However, like a marathon, not all of these companies are moving at the same pace.
In this article, I am going to outline three stocks that could emerge as leaders of the AI movement. I'll provide details around the investments that each company is making and supplement this detail with some valuation commentary. Let's go!
1. Alphabet
The back half of 2022 and the first quarter of 2023 were rather tumultuous for Alphabet (GOOGL 10.22%) (GOOG 9.96%). From the third quarter of 2022 to the first quarter of 2023, the company witnessed year-over-year declines in advertising revenue from YouTube, thanks in large part to short-form video competitor TikTok. Moreover, Alphabet's cloud business was consistently unprofitable until the first quarter of this year.
In keeping with the marathon theme above, it was beginning to look like Alphabet's best days were in the rearview mirror, and competitors were passing it by. Yet over the last several months, Alphabet has continued investing in its AI roadmap, and the company's second-quarter earnings provided investors with an encouraging preview of what the future may hold.
During the first quarter of 2023, Alphabet's Cloud unit posted its first-ever operating profit. While this was notable, the company really shocked investors by posting another Cloud profit for the quarter ended June 30. On the earnings call, Alphabet CEO Sundar Pichai explained that the cloud business is leveraging generative AI applications across a multitude of products and services. The innovations the company is making in cloud cybersecurity, for example, have garnered the likes of enterprise customers such as Pfizer.
Another notable takeaway from the Q2 report was Alphabet's progress in advertising, which grew 3% year over year. Although the company's Search business grew 5% annually, the big winner under the advertising umbrella was YouTube, which returned to growth after several quarters of decline. In my prior piece analyzing Alphabet's full earnings results, I point out that management credited its AI-powered tools and services as a catalyst to return to growth, particularly with advertisers.
Image source: Getty Images.
2. Microsoft
Another name that consistently floats around in AI headlines is Microsoft (MSFT 1.82%). Perhaps the darling that jump-started all of the hoopla around AI was the tool known as ChatGPT. What investors should understand is that ChatGPT is a service, and the company behind the innovative chatbot is called OpenAI.
Now, what you may already know is that back in January, Microsoft committed to a $10 billion investment in OpenAI to be spread over several years. But did you know this wasn't Microsoft's first time investing in the ChatGPT parent? The company invested a $1 billion sum into OpenAI back in 2019.
So, while AI may be the new buzzword on Wall Street, it's clear that Microsoft has been dabbling with the technology for several years. Moreover, like its Big Tech counterpart, the company has already outlined a number of projects for its AI roadmap.
Although Microsoft has historically been known for its productivity tools such as Office as well as hardware devices like laptops and its gaming product Xbox, earlier this year, the company showcased its interest in tapping into the creator ecosystem. OpenAI is home to a number of artistic products that can be used for endeavors such as graphic design.
Additionally, the company has previously hinted that it will be releasing a subscription product dubbed Copilot, which is aimed at marrying the power of AI into its Office suite of products, including Excel, PowerPoint, and Teams.
3. Amazon
When it comes to AI, perhaps the stock that has me most excited is Amazon (AMZN 3.43%). Similar to Alphabet, Amazon has been no stranger to some tough investor sentiment over the last several quarters.
While inflation is beginning to cool, its current state still remains elevated over the Federal Reserve's long-term target of 2%. The combination of lingering inflation and high borrowing costs has impacted consumer discretionary spending, which can directly impact an e-commerce business like Amazon.
Investors should keep in mind that Amazon, Alphabet, and Microsoft can all be considered diversified businesses. In other words, while Alphabet is largely an advertising model, Microsoft is predominantly a software business, and Amazon is likely best known for its online shopping platform, each of these companies is far more prolific. For Amazon investors, I suggest keeping an eye on the company's cloud application called Amazon Web Services (AWS).
As management hinted during the most recent earnings call, AWS is investing aggressively in AI capabilities, including its own chips. Given the company's consistent improvements in free cash flow, combined with AWS closing in on $100 billion in annual revenue, it's hard to imagine how calculated investments in AI won't benefit Amazon in the long run.
A hard look at valuation
GOOGL P/S Ratio data by YCharts.
The chart above shows the price-to-sales (P/S) ratio for Alphabet, Amazon, and Microsoft over the last five years. The basic takeaway is twofold. First, Microsoft trades at a meaningful premium to its Big Tech cohorts. However, despite this disparity, all three stocks are trading well below the five-year high.
This could suggest that other smaller companies, namely growth stocks, making waves in the AI boom are winning most of the attention from the capital markets. Therefore, blue chip stocks like the ones in this article may be overlooked at the moment.
Long-term investors should keep in mind that the companies outlined in this article are not operating at peak growth. To be more specific, while revenue and operating profits are growing across several categories, each company is still far from out of the woods.
From my purview, I think that a large cohort of investors is leaving Big Tech and looking for growth elsewhere. While this could be a profitable strategy, I struggle to make a case for passing up the three names focused on in this piece. The AI revolution is a marathon, and it will take some time for investors to get a true glimpse of which companies are emerging as leaders.
I believe that should inflation continue to cool down and the Fed employ a tapering strategy within the next 12 to 18 months the capital markets will experience more pronounced activity. If this is the case, I believe that Alphabet, Microsoft, and Amazon will all be well positioned to thrive in a bull market, thanks in large part to the foundation each is currently laying as it relates to AI.
