Artificial intelligence (AI) has been a hot potato since OpenAI released its ChatGPT platform in November 2022. The AI boom is in full swing 16 months later, sending many AI stocks skyward.
But every AI stock can't be a winner in the long run. In my eyes, it's not enough to simply have a finger in the AI pie. Before putting my hard-earned money to work in a promising AI investment, the company and stock face my checklist of 4 must-have qualities.
To be clear, the prospective AI investment under my microscope doesn't have to pass every test, as extreme strength in one area can compensate for weakness in another. But the more checkboxes I can fill, the more likely I am to buy a few shares in the end.
And here's what I'm looking for:
1. Game-changing innovation
In the fast-paced world of AI, it's crucial to separate the true innovators from those simply repackaging old ideas. Look closely for signs of proprietary technology: unique algorithms, models, and frameworks backed by a strong patent portfolio. These are strong indicators of not only innovation but also a company's ability to defend its market position.
Additionally, a relentless commitment to research and development (R&D) is essential for companies hoping to stay ahead in the AI game. Consistent breakthroughs and publications may not be flashy, but they signal a company invested in the long-term evolution of the field. These are the potential game-changers worth considering for your portfolio.
2. Real-world use cases
Let's be clear: the most compelling AI companies aren't just about cutting-edge technology; they're about solving real-world problems. Look beyond the buzzwords and focus on companies that target significant pain points and inefficiencies businesses and industries face. Have they helped clients generate revenue, cut costs, or significantly streamline processes with their AI solutions? This is a strong indicator of potential investment value. And I'll always prefer having an actual app or cloud-based platform available over grandiose technology claims without a usable version.
Beyond immediate problem-solving, scalability is essential. Consider the technology's potential for wider adoption across industries or its ability to adapt to varying needs. This versatility signals a company's capacity for substantial growth and market dominance. Look for evidence of success, such as widespread adoption of their solutions and an expanding customer base. These are reliable indicators of an AI company positioned for long-term success.
3. Financial health
Even the most groundbreaking AI can't save a company with a disastrous balance sheet, stalled top-line growth, and negative cash flows.
That's why savvy investors need to look beyond the pure technology and scrutinize the financial statements. A little homework goes a long way, and evaluating the dry numbers gets easier the more you do it. Try to make a habit out of checking a few important figures before taking action on any stock -- AI-related or not. Your selection of useful data points will surely grow over time, making you more selective on those random walks down Wall Street and Silicon Valley.
Some might call it being "choosy" or "picky," but don't worry about that. You're managing real money here!
The ideal AI company has more than a great idea and promising technology. Look for innovators that are making money, show sustainable (or even accelerating) revenue growth, and -- most importantly -- at least have a realistic long-term roadmap to profitability. The AI stuff needs to be more than a cool science project, but a viable business with realistic profitability targets.
4. Reasonable valuation
Stock valuations are getting a little silly in the AI market.
Shares of number-crunching chip designer Nvidia (NVDA 0.03%) have soared 480% higher since the ChatGPT system it powers entered the market. System builder Super Micro Computer (SMCI 3.84%) posted an even steeper 998% gain over the same period. These companies have seen impressive business growth and generous profits from AI-based hardware sales, but they still look expensive.
Super Micro shares are changing hands at 6 times sales and Nvidia's price-to-sales ratio stands at 37. That may not sound too bad, but these hardware companies generally trade at much lower ratios.
SMCI PS Ratio data by YCharts
These companies are leaders in a red-hot sector, but their lofty valuations should still make you do a double-take.
I mean, Nvidia is a great company with strong business trends and a bright long-term future, but the stock seems to have soared too fast for its own good. So I took some of my own Nvidia profits off the table recently, reinvesting that lovely cash in some lower-priced growth stock ideas. Noted growth investor Cathie Wood is doing the same thing, selling a small slice of ARK Invest's massive Nvidia holdings every week.
I'm still a happy Nvidia shareholder and so is Cathie Wood. We're just not buying that richly valued stock right now, and there's no shame in cashing in some profits along the way.
Take it easy out there, dear AI investor
So there you have it -- the four most important things I look for in every potential AI investment. Most of these concepts apply to any stock, especially in the tech sector at large.
Your criteria may differ based on your personal investment goals and understanding of the ever-changing AI opportunity. For example, you might care deeply about ethical AI practices and data privacy, or look for top-notch management teams before anything else, or maybe you want an ironclad technology infrastructure with bullet-proof security. I want those things too, but only as tiebreakers after assessing the four essential qualities above.
Whatever your individual investment criteria, remember to stay grounded amid the AI excitement. It pays to focus on companies showcasing robust business practices and sensible valuations. This approach helps ensure you're not just caught up in the moment, but making money management decisions that stand the test of time.
