AI’s Second Wave: Opportunities Beyond the Giants

In the rapidly evolving world of technology, the advent of artificial intelligence (AI) has been nothing short of revolutionary. As AI continues to advance, it not only presents disruptions and opportunities but also brings risks for investors. Morningstar Investment Management (MIM) experts have highlighted an intriguing perspective for 2024—looking beyond the significant AI players and focusing on what they call “Second Derivative Plays.” This approach offers a unique opportunity for investors to tap into the AI theme without the high valuation risks associated with big AI companies like Nvidia.

The AI gold rush

Investor interest in AI has been staggering, evidenced by significant inflows into AI and Big Data thematic funds on a global scale, as well as soaring share prices for major AI players. However, MIM suggests that investors should consider exploring the untapped potential of Second Derivative Plays in the AI space instead of following the crowd.

What are the second derivative plays?

Derivative Plays are not the traditional chip makers or technology interface providers. Instead, they are entities that can effectively integrate AI into their operations, driving new revenue growth opportunities by capitalizing on the ripple effects of AI.

Examples of Second Derivative Plays

• IT consulting companies: Many lack the expertise and financial resources to develop and maintain their AI platforms. IT consulting companies with technical capabilities in artificial intelligence services can step in to meet this demand.

• Data Management Providers: Hosting enterprise data used for AI modeling is crucial. Data management providers that offer secure and efficient data hosting services for AI applications represent a significant Second Derivative Play.

• High-Speed Networking Providers: AI requires lightning-fast data processing to train its models effectively. Companies with the highest networking speeds can capitalize on the increased service demand from investments in generative AI.
• Data Centers: The growth of AI will lead to an explosion in the demand for computing power and data storage. Data centers are poised to experience a substantial and sustained increase in business as AI applications expand.

While the excitement surrounding AI is undeniable, investors should exercise caution and consider the long-term sustainability of their investments. Instead of chasing short-term winners during periods of hype, it may be more prudent to focus on companies with “economic moats.”

What are economic moats?

Economic moats are competitive advantages that protect a company from being easily overtaken by competitors. MIM experts recommend looking for companies with economic moats, as they may be less susceptible to disruption from AI. These moats can be based on:

• Customer Switching Costs: Companies with high customer switching costs, making it difficult for customers to switch to competitors, are well-protected.
• Unique Data Sets: Firms with access to proprietary and valuable data sets have a competitive edge, as this data can be leveraged for AI-driven insights and innovations.
• Strong Brands: A well-established brand can provide trust and recognition that is difficult for newcomers to replicate, serving as a protective moat.

The value of permanent change

Investors should also be vigilant about identifying permanent changes in industry structures and customer preferences. As AI continues to reshape industries and consumer behavior, businesses that adapt and innovate benefit most.

The AI landscape constantly evolves, offering many opportunities beyond the well-known giants in the field. Investors interested in AI should consider the concept of Second Derivative Plays, which encompass companies that effectively integrate AI into their operations to drive growth. Additionally, focusing on businesses with economic moats can provide a degree of protection against AI-driven disruptions. As 2024 approaches, it’s clear that AI’s second wave will bring challenges and winners for those who navigate the landscape wisely.