How can investors cut through the noise to find AI winners for different types of equity allocations?
Artificial intelligence (AI) is a transformative technology with the power to change the world. While enthusiasm for AI has fueled recent equity-market gains, long-term investment success may ultimately hinge on applying lessons from past disruptive episodes.
AI-fueled tech-stock valuations are soaring, with investors funneling capital into established mega-caps and speculative ventures alike. But which AI stocks will have staying power, and which are more vulnerable if AI’s sizzle starts to fizzle? At some point, we believe that AI will no longer be a rising tide that lifts all boats, which means investors must be highly selective.
One of the more frequent questions we get these days is whether AI is in a bubble. With growth-stock valuations soaring, we believe caution is warranted. But we must first distinguish between the equity markets and all things AI in a broader context.
What Constitutes a Bubble?
We believe it’s misguided to label the AI revolution as a bubble. More likely, we’re still in the early stages. AI has the potential to transform every facet of modern life with newfound innovation and efficiency gains. The “DeepSeek Moment” in early 2025 marked an inflection point in the adoption of AI inferencing, and we’re now seeing accelerated AI output and vastly improved large-language models.
As for AI stocks, optimism is carrying the day, even though most hyperscalers have yet to turn their enormous investments into profits. Most have the cash flow and scale to withstand the delay until new data centers pay off. But smaller, less-profitable companies don’t have that luxury. And when market enthusiasm leads to a mispricing of companies with highly levered business models, bubbles can burst.
Similar to Dot-Com? We Don’t Think So
Naturally, the temptation is to compare the current environment to the dot-com era of the late 1990s and early 2000s. Beyond a sharp run-up in stock valuations, however, the two eras are structurally quite different.
The dot-com bubble was characterized by a rapid rise in equity markets spurred by investments in internet-based firms. Some had no sustainable business models and little hope of ever turning a profit, yet investors paid up for them just the same. Eventually, the dot-com bubble burst because too few business models could be monetized. But investors should also keep in mind that the internet and mobility gave birth to a new generation of tech leaders like.
Another big difference is the breadth of firms taking part in today’s boom. The current AI-beneficiary rally is being driven by well-capitalized mega-caps, as well as a small group of speculative, early-concept stocks. We’re also seeing an enormous amount of capital flowing into private companies.
Still, there are reasons for concern.
This initial capex phase of the AI infrastructure boom has largely been funded by hyperscalers with balance sheets capable of supporting massive capital outlays. To be profitable, the underlying technology must continue advancing to justify rising AI-related capital expenditures. In many ways, mega-caps simply can’t afford not to spend. This puts tremendous pressure on companies already deploying more than half of their operating cash flows into capex.
Moreover, the next phase of the AI build-out is being fueled by less-stable sources—including debt-financed expansion, inflated private company valuations, circular financing arrangements and risky private credit structures. That could portend trouble down the road.
True innovation tends to happen incrementally rather than on the linear path we’re inclined to expect. Often, it’s the timing mismatch that causes market corrections rather than any fundamental flaws in the infrastructure build-out itself.
The Importance of Pricing Power
Given AI’s potential transformational impact on barriers to entry and future business models, the question is which companies can maintain pricing power and generate profit pools. We believe companies with pricing power have three key hallmarks: defensible business models, strategic industries and strong balance sheets.
At some point, clear winners will emerge, justifying the rich market caps they’ve been awarded, while others will be left by the wayside. Historically, what bursts a bubble is often the debt market when cash-strapped companies fail to pay interest owed. For this reason, debt service payments bear watching.
So how should investors approach this exciting yet uncertain moment?
For more risk-tolerant investors seeking thematic growth, we think the key is to identify disruptive companies that are changing the status quo with truly innovative solutions and sustainable long-term growth potential. These include businesses with differentiated intellectual property, as well as fortified franchises with strong competitive advantages. Both types of disruptors should offer durable growth prospects with a clear path to profitability.
Investors seeking defensive equity allocations might not think that AI-driven companies are a good fit. Yet we believe that firms with high-quality business models, a degree of stability and relatively attractive valuations can play a role in defensive portfolios. Here, we look for companies that offer both meaningful upside from AI exposure and the risk reduction that comes from strong fundamentals in their core businesses.
AI holds plenty of promise despite its myriad risks. As we see it, it’s a great time to be an active investor. A disciplined focus on businesses fundamentals can enable investors to uncover old-fashioned success in a revolutionary new field.
