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By Todd Ahlsten, CIO, Parnassus Investments
I've been down to Silicon Valley countless times in my 29 years studying the semiconductor industry. The several-day trip I just completed, where I sat down with the CFOs and other executives of major chipmakers, was unlike any other I've experienced. That's because the AI boom driving the semiconductor industry is unlike any cycle I've ever seen.
I recently wrote about dynamics of chip cycles, in which dramatic disparities in the demand for chips and the capacity to make them can cause whiplash-like swings far more volatile than those in other industries. The promise and demand for AI computing is creating a cycle that is very different from the classic cycles for PCs, memory chips and smartphones. Demand drivers are exponential this time around, based on accelerated computing and generative AI. The drivers of the cycle are some of the most profitable and cash-rich companies in the world. Tier 2 players and sovereign nations looking to train AI models on local data are also looking to invest in this mega cycle.
The chip sector has been the best performer so far in the first quarter of 2024, growing by 29%. And yet we may still be early in what looks like an extended cycle. When I looked into the eyes of the semiconductor CFOs I met, I detected a high level of confidence in future demand. What I took away from those meetings is that the current AI-driven cycle seems to have a secular consistency, although there is likely to be a lot of volatility along the way.
Many are speculating that these elevated valuations are a sign of another tech bubble. Unlike the dot-com bubble 24 years ago, which had substantial funding from seed capital and debt-fueled investment against the promise of potential future growth, this boom is largely funded by the current influx of cash from deep-pocketed tech operators like Microsoft, Meta, and Oracle, to name a few.
The accelerated computing required to run powerful AI models could push demand beyond the graphics processing units (GPUs) required by Nvidia and AMD. It will also require central processing units (CPUs) to run servers in data centers; a new generation of high-bandwidth memory chips; and application-specific chips to run custom AI models at tech giants like Meta, Google and Amazon.
No one can say for sure how the AI investment cycle will play out in the long term. Many past semiconductor cycles have ended in hubris and overhyped trends. But I think the secular dynamics of AI will be very powerful. There is an exponential amount of computing power needed in processing data, and training and inferring AI models, before they can be monetized. This can take years to build. During my few days in Silicon Valley, no one talked about the economy, Fed interest rates or cyclical factors. Artificial intelligence is so much a force of nature. While I've learned a lot over eight economic cycles, it's also important to remain dynamic, always learning and evolving in the face of the revolutionary changes that accelerated the promises to bring computing.
The economy beyond AI
In most respects, my overall view of the economy hasn't changed much in the first quarter. The economy so far this year has been pretty good—GDP is growing and the job market has been relatively strong. But inflation remains stubbornly high and the mixed effects of high interest rates continue to emerge. The question is: how much does the AI dominate the story? I think the AI economy could continue to drive a massive wave of capital investment, potentially creating the conditions for a bubble. But the real economy outside of AI is likely to be fairly stagnant, especially in the second or third quarter, when GDP may slow to near-flat growth.
The coming months continue to have some uncertainty. The market is off to a strong start in the first quarter. However, I continue to see a lot strong cross currents of possible economic headwinds that may hit the market. And I think that could happen if the lagged effect of long and variable interest rates finally hits home and the labor market softens.
Positioning for economic sustainability
We believe the best way to navigate the type of economy and market we're seeing is by being very selective about the companies that earn a place in our concentrated portfolios.
Exposure to AI through technology and semiconductors gives us the opportunity to grow as these companies expand their business, driving the AI economy. We look for quality companies with AI exposure trading at reasonable prices, as well as broad, stable and less economically sensitive companies abroad. What does this look like? In our core equity portfolio, our top two holdings are Microsoft ( MSFT ) and Alphabet ( GOOGL ), and we have semiconductor positions in Nvidia ( NVDA ), Applied Materials ( AMAT ), and Micron ( MU ). Other properties — such as Salesforce ( CRM ), Oracle ( ORCL ), Intuit ( INTU ) and Adobe ( ADBE ) — have revenue resilience that we believe can remain resilient during a downturn.
Defensively, we aim to hedge against potential economic slowdowns and uncertainties with economically resilient businesses that may outperform in this environment. We look for opportunities in companies that offer high recurring revenue and stability in down markets, such as auto parts retailer AutoZone ( AZO ), food distributor Sysco ( SYY ), discount retailer Costco ( COST ), paint manufacturer Sherwin Williams ( SHW ) and residential recycler Waste Management ( WM ). We think financial exchanges like CME Group (CME) and Intercontinental Exchange (ICE) can also do well during periods of volatility. We also like solid life sciences companies like Danaher ( DHR ) and Thermo Fisher Scientific ( TMO ) that not only deliver solid earnings growth, but serve a life science industry that may experience a cyclical recovery.
While the prospect of a tech bubble could certainly be real, the success these businesses have experienced is contributing to the widening gap and steady earnings growth that could continue to propel these stocks forward. And on the other hand, we are waiting for the pressure valve in the economy to be released from the impact of higher rates.
One of the privileges of being an asset manager based in the Bay Area is our proximity to Silicon Valley, where we can witness the evolution first hand. Right now, this is a very special time in that corner of the economy.
To learn more, visit | www.parnassus.com or call (800) 999-3505.
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