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Strategy Update

Artificial Intelligence

Through much of last year, technology stocks dragged the market lower. There were many
reasons for this underperformance, but put simply, investor expectations and optimism for the industry had run well ahead of reality during the pandemic. In light of these heavy corrections, it is not surprising that they have rebounded this year. What is surprising is the extent to which the technology sector has recovered – to the exclusion of most other industries – making for a very narrow, but powerful rally in the stock market. This recovery, sensible at first, is now looking more like a flood of momentum buyers hoping to cash in on a singular theme: artificial intelligence.

In January of this year, Microsoft announced a $10 billion investment in a new company called
OpenAI, which had released a trial version of its product, ChatGPT, late in 2022. This trial served as an introduction for many to the potential of artificial intelligence (AI), and Microsoft’s large investment signaled to the stock market that this relatively unknown company and their new product should be taken seriously.

Six months later, nearly every major technology company has framed their business and long-
term outlook within the context of AI. Many companies have come to market with competing or complementary offerings, and the stock market overall has added trillions of dollars of market
capitalization that can be traced back to this singular theme. The seven largest companies in
the S&P 500 Index, all technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta), have spent considerable time and money this year connecting themselves to AI. In the first half of 2023, the shares of these companies increased collectively by 60%, at a time when most companies in other industries barely budged. Put another way, in an index of five hundred companies, the return from these seven companies made up three quarters of the return of the entire index, such was the enormous impact of their price rise.

To help understand the enthusiasm (and criticism) around AI, it may be useful to attempt a
rudimentary explanation of the technology. ChatGPT is a piece of software constructed around
a massive repository of language, i.e. digitized libraries and Wikipedia entries. A user will ask a
question or give a prompt, ChatGPT will analyze its library, and, in an extreme simplification, it
will deliver the response it deems most likely or probable based on the prompt. This approach and sometimes the result – can be at odds with the attachment most of us have to there being a “right” answer to a question. ChatGPT and other products like it are not searching for any right answer. They have been exposed as giving a “wrong” answer to somewhat simple questions, and at the same time giving incredibly interesting responses to equally complicated prompts, almost feeling “creative” in the process. Despite their faults, these are impressive feats of technological innovation – although the last decade has shown that not every technological feat necessarily produces social good or meaningful economic output.

Still, the stock market has added trillions of dollars of value this year. Companies providing the
computing infrastructure to build these powerful tools have soared in value; companies that
are building competing models to ChatGPT have generated excitement; and any technology company that can argue for a compelling end-use case has also attracted investors. From a personal assistant that can draft emails, to a well informed AI-driven “travel agent” that can create an itinerary, to a program that can potentially write the lyrics to the next hit pop song, the economic possibilities are compelling.

And yet, as with most big and compelling investment stories, there comes a point when
enthusiasm exceeds reality, and momentum buyers looking for a quick profit start to enter
the fray. We need only look back two years to see the last time this happened. In a world of
pandemics, it was thought, we would only shop online and we would all check in with our doctor via Zoom, in between numerous other virtual experiences. Undoubtedly, our lives post-pandemic are a bit different, and a bit more dependent on technology. Yet the shares of many pandemic-themed companies surged in a buying frenzy that collapsed even more quickly.

There will certainly be durable winners from the deployment of ChatGPT and its competitors.
It will change how we use existing technology. It will be valuable when used for good, and
dangerous when used poorly or to devious ends. But it is also likely generating too much enthusiasm within the stock market at present, driving the technology sector to massive short-term gains that may be difficult to sustain.

Current Strategy

The stock market has felt broadly split between the winners within the technology space and
everything else, with shares of many companies only inching forward this year. Although
our existing investment portfolio and new investments made in 2023 mostly fell outside the
technology sector, we managed many good successes to start the year in a variety of other
industries. We added investments in the healthcare and industrial sectors along the way,
although in each case the ideas were the result of unique opportunities we saw, rather than an
embrace of any broad thematic or economic outlook. Hopefully, we have structured a portfolio
of investments that stands to benefit under a broad range of economic outcomes or market
shifts. Today the S&P 500 Index has increasingly become exposed to the technology sector, and we are concerned that the largest companies are becoming overcrowded by investors buying shares directly – activity which is then amplified by the ETFs and other funds that match the Index in its composition.

As the stock market rally has gone on, we have found opportunities to take some gains and shift
funds to cash or bonds. With yields on cash and short-term bonds nearing 5%, the bar is set
higher for stocks to exceed that return. We view the math as challenging for stocks, at a time when the economic outlook is still cloudy and the largest sector within the market is showing signs of stretched valuations. While some investors continue to pull cash from the sidelines and pile into the most popular stocks of this market, we feel it is increasingly important to lean the other way. We have sold a few positions that feel most economically exposed, and have either built up some defensive positions (in healthcare, for example), or left the proceeds in cash.

This chapter of economic history is not yet finished, and it remains to be seen whether it will
finish like all past episodes of inflation-fighting via interest rate increases – with a recession – or if there is a different and better end in store. The current data is mixed, in our view. Economic forecasting is always guesswork, and sometimes even a proper view of the present is left to the eye of the beholder. We see an economy where employment is generally strong and inflation is still high, but clearly headed in the right direction. We also see an economy where many consumers are underwater on car loans, bank lending is tightening and consumer spending is constrained. Until we have a slightly clearer view on where we are and where we may be headed economically, the safety and income provided by cash and bonds is compelling, especially as the stock market approaches its old highs.