AI has been the biggest trend in the stock market in the last two years and this was reflected in the share prices of AI companies.

Early AI beneficiaries such as Nvidia (NVDA), and Microsoft (MSFT) have seen huge upsides.

This was a much-needed boost for the stock market after the terrible 2022 decline when the Nasdaq dropped nearly one-third.

The performance of AI companies has managed to keep the underperformance of tech as a broader industry under wraps.

We can see this by looking at the S&P 500 tech ETF (XLK), up 17% year-to-date which seems okay for the 10-month time frame.

Yet, having a deeper look, one can realize that AI beneficiaries Nvidia, Microsoft, and Apple (AAPL) account for more than 40% of the ETF and carry the overall performance.

Tech companies had relied on low interest rates to fuel rapid growth. So, when the Federal Reserve started rate hikes and many venture investors and banks turned off money taps, some companies began to struggle.

Even the largest tech companies such as Alphabet (GOOGL) and Meta (META) went through massive layoffs. While some have bounced back thanks to advancements in AI, many others continue to struggle.

According to Bloomberg, the S&P 500 IT sub-index saw revenue growth below 7% in the past 12 months, down from the five-year average of 10%, with about 75% of companies growing more slowly than historical levels.

Also, earnings per share of the index rose by 16% in the same period, a decline from the 21% average over the previous five years.

Among the struggling non-AI names, there are once-upon-a-time tech giants PayPal (PYPL), SNAP (SNAP), and Zoom (ZM). Currently, they are sitting 74%, 88%, and 87% off from their all-time highs in 2021 respectively.

And they are not giving signals that suggest they will get back to their brightest days anytime soon.

AI companies have been more profitable than non-AI ones in the tech space.

We can see this by looking at the companies’ Uniform return on assets (“ROA”).

As you can see, the Uniform return on assets (“ROA”) of the AI companies has averaged slightly over 25% over the past five years while pushing the 30% level in 2021.

Thanks to the AI boom, Wall Street analysts forecast these companies to see returns reach new peaks in 2025 and beyond.

Conversely, the Uniform ROA of non-AI tech companies has been around 9% in the same period. In 2024, it is forecast to be at the lowest level it has been in the past several years.

Take a look…

In short, you need to be more selective than “buy tech” if you’re trying to ride the AI boom.

In the bigger picture, the success of AI companies seems to brighten the tech space overall, which is a bit misleading. These companies have been more profitable for a while, and that’s only going to become more pronounced.

Once we have a closer look and isolate the non-AI companies in the industry, we can see that other parts of the industry are still struggling.

Investors would be wise not to just jump in and buy a technology ETF like XLK if they want to benefit from the AI boom.

They need to be smarter to pick off the companies benefitting from the boom.

Best regards,

Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research

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