Late last year, we highlighted how global equity indices had become highly concentrated, with US equities tied to the Artificial Intelligence (AI) theme increasingly dominant. Since then, rather than easing, index concentration has intensified. While investor enthusiasm for companies building AI infrastructure has waned, with their shares firmly in negative territory over the year-to-date, it has shifted decisively towards those supplying the infrastructure – most notably semiconductor companies that produce commodity-type DRAM and NAND memory chips. These chips are considered the ‘picks and shovels’ of the AI gold rush, and their producers have been among the biggest recipients of the significant capital expenditures undertaken by the large technology firms developing data centres.
The semiconductor industry is notoriously cyclical, yet the analyst consensus is now forecasting “structural growth” of increasing scale and durability for this group of companies. By way of example, Micron, one of the world’s three dominant DRAM manufacturers, is expected to earn net profits of c$84bn this year. This far exceeds the total cumulative profits the company has earned in the 42 years since it was founded. More striking still, profits are expected to more-than double again next year, and grow a further 10% the following year. This pattern is broadly replicated across major competitors, SK Hynix and Samsung Electronics.
As history has demonstrated time and again, extraordinary profits attract competition, bringing additional capacity to market and ultimately leading to lower component prices, weaker profitability and falling share prices. With market leaders committing to hundreds of billions of dollars of new capacity, and with new competitors emerging in China, history suggests a sharp rebalancing between supply and demand is usually a question of when rather than if.
Notably, in an echo of prior market manias, investors have aggressively used leverage1 to amplify their exposure to these companies, driving share prices sharply higher. As a result, these companies have accounted for the majority of recent market returns.
Over the past few days, however, investors have started to question the prudence of extrapolating rapid near-term earnings growth far out into the future. Having risen sharply for much of the past year, the chart shows that the shares of the three major memory chip stocks have started to come under pressure amid heightened volatility.
As concentration continues to rise, many market-cap weighted equity indices are arguably becoming an increasingly binary bet on the future profitability of the AI ecosystem, a fact that we believe should be of great concern to investors. To address this, we are ensuring that Heronsgate portfolios are well diversified across themes, regions and company size, reflecting the old investment adage that ‘diversification is the only free lunch in finance’ – a principle we believe remains as relevant today as ever, and one that investors are having to work ever harder to adhere to
