Enterprising Investor: Ken Lauden on Investing in the Age of AI

Hosted by Mike Wahlberg | Released on August 1, 2024 | CFA Institute

Introduction

In the latest episode of Enterprising Investor, hosted by Mike Wahlberg from CFA Institute, the spotlight shines on Ken Lauden, the portfolio manager of Buffalo Fund's Blue Chip Growth Fund. With over 30 years of experience as both a sell-side analyst and buy-side portfolio manager, Ken brings a wealth of knowledge to the discussion on the current state and future of investing in an era dominated by artificial intelligence (AI).

Market Overview

Ken Lauden opens the conversation by addressing the tumultuous market conditions of the past year. He points out two primary challenges:

1. Shifting Market Narratives:

   • [01:51] Ken Lauden: "There's a shifting narrative that's at least starting to emerge regarding a possible regime shift towards the other 493 stocks in the S&P 500 and away from the so-called 'Magnificent Seven.'"
   • The focus is moving away from high-flying tech giants—dubbed the Magnificent Seven—towards a broader range of S&P 500 stocks. This shift stems from growing complacency among investors regarding the monetization of AI infrastructure investments made over the past 18 months.

2. Upcoming Earnings Week:

   • [02:00] Ken Lauden: "With Microsoft, Meta, Amazon, Apple, and AMD all reporting this week, there's big questions and uncertainties on the AI CapEx spend going forward into 2H24 and certainly into '25."
   • This earnings week is pivotal, with major tech companies set to reveal insights into their AI capital expenditures and broader macroeconomic factors affecting their performance.

Mike Wahlberg further probes the macroeconomic backdrop, highlighting elements like rate cuts, equity risk premiums, and other investment themes that have influenced market dynamics over the past year.

AI's Current State and Potential

A significant portion of the discussion centers on the role of AI in shaping investment strategies and market expectations.

Ken Lauden expresses a tempered view of AI's current impact:

• [07:55] Ken Lauden: "AI is neither transformative nor revolutionary today, far from it."
  • While acknowledging AI's eventual potential, Ken argues that current large language models (LLMs) like those developed by OpenAI lack the transformative capabilities expected by investors. They excel in automating language-based tasks but have yet to produce a "killer app" that drives substantial enterprise adoption.

Challenges with Current AI Technologies:

• Hallucination Toxicity: LLMs sometimes generate inaccurate or misleading responses.
• ROI Concerns: The return on investment from AI implementations has been lower than anticipated, with some enterprises seeing only 20-30% ROI compared to the expected 50%.
• Data Security and Privacy Issues: Concerns over how AI models are trained and the ethical implications of data usage.

[09:46] Ken Lauden: "For it to be adopted broadly by the enterprise and for consumers, you've got to get rid of these bugs and have more consistency in generating the type of productivity savings."

Future Directions:

• Transition from Search and Answer to Action:
  • Current AI primarily serves as a tool for search and answering questions. The next phase requires AI to perform actionable tasks autonomously, such as managing personal schedules or executing complex transactions without constant user prompts.

Hyperscalers' Investment and Concerns

The conversation delves into the substantial investments made by major tech companies—Amazon, Microsoft, Google, and Meta—in AI infrastructure.

Investment Timing and Monetization:

• [15:19] Ken Lauden: "Monetization timing is the concern. Nobody, including the hyperscalers, really know when end-user demand will inflect."
  • These companies have poured billions into AI infrastructure without a clear timeline for when these investments will translate into profitable returns.

Impact on Nvidia:

• [16:41] Ken Lauden: "I would imagine about 45% of Nvidia sales in the last quarter were from these hyperscalers. They view AI as existential."
  • Nvidia, a key player in providing AI hardware, sees a significant portion of its revenue tied to these tech giants' AI ambitions. However, the uncertainty around AI demand poses risks to sustained growth.

Investor Sentiment and Potential Pushback:

• [18:04] Ken Lauden: "If we don't see the sort of demand start to manifest by 2025, then I think you're going to see investors start to push back on the hyperscalers."
  • Investors may demand more restraint in AI investments if tangible returns are not evident within a reasonable timeframe, potentially leading to a reevaluation of these companies' valuations.

Power Consumption Issues

A critical yet often overlooked aspect of AI advancement is the significant increase in power consumption required to support AI workloads.

[19:11] Ken Lauden: "Compute power is going to grow at like 250% a year while the growth in the grid capacity is going to be 2.5%."

• The exponential growth in computational demands for AI is projected to far outpace advancements in electrical grid capacities, posing a bottleneck for sustained AI development.

Environmental and Infrastructure Strain:

• Data Centers and Grid Usage:
  • [19:53] Ken Lauden: "Data center consumption was going to be up to 19% of grid usage from 4% today."
  • This increase places additional strain on already aging electrical grids, which are grappling with other rising demands such as electric vehicle (EV) charging.

Potential Solutions:

• While advancements in chip efficiency and leveraging renewable energy sources like nuclear power offer some respite, Ken emphasizes that these measures are merely "band-aids" and do not address the underlying issue holistically.

Investment Strategy Recommendations

Given the current landscape, Ken Lauden offers strategic advice for investors navigating the AI-driven market shifts.

Defensive Portfolio Construction:

• Diversification Beyond the Magnificent Seven:
  • [20:52] Ken Lauden: "The gap between the investment in AI infrastructure, the enablers versus the adoption of that infrastructure by large commercial enterprises is looking like it's going to be bigger than what we had anticipated."
  • To mitigate risks associated with over-reliance on a handful of high-flying tech stocks, Ken recommends a more diversified approach.

Sector Overweights:

• Healthcare and Industrials:
  • Emphasizing sectors less susceptible to AI investment timing risks, Ken suggests overweighting positions in healthcare and industrials, particularly those involved in electrification and water purification.

Pragmatic Weighting of AI Supercycle Names:

• Balanced Exposure:
  • While maintaining exposure to AI leaders like Nvidia and Microsoft, Ken advises against allowing these stocks to dominate the portfolio. Instead, allocate them in a manner that reduces concentration risk and aligns with long-term investment horizons.

Long-Term Perspective:

• [20:52] Ken Lauden: "Own these names, just own them in probably more pragmatic weights to where you're not overexposed."
  • Investors are encouraged to adopt a long-term view, recognizing the cyclical nature of AI adoption and the potential for overvaluation driven by current market sentiment.

Personal Insights from Ken Lauden

In a reflective segment towards the end of the podcast, Ken Lauden shares personal experiences and advice:

• First Job in the Industry:

  • [24:38] Ken Lauden: "My first job in the institutional investment industry was a sell-side analyst covering healthcare service stocks."

• Advice to Younger Self:

  • [25:00] Ken Lauden: "If I could go back and take myself for coffee on my first day, I probably would have been more focused as a generalist rather than a sector specialist."
  • Emphasizing the value of a broad investment perspective, Ken suggests that being a generalist might have allowed him to better capitalize on emerging investment opportunities over his extensive career.

Conclusion

Enterprising Investor wraps up the insightful conversation with Ken Lauden, offering listeners a comprehensive understanding of the intricate balance between AI's potential and its current limitations within the investment landscape. Ken's cautious yet optimistic outlook underscores the importance of strategic diversification, long-term planning, and vigilant market analysis in navigating the age of AI.

[25:26] Mike Wahlberg: "I've been speaking today with Ken Lauden, portfolio manager of the Buffalo Fund Blue Chip Growth Fund. Thanks for sharing your thoughts with us today. It was a great chat."

Key Takeaways:

• AI's Maturity: While AI holds transformative potential, current technologies like LLMs are not yet fully revolutionary, requiring advancements for broader enterprise adoption.
• Market Dynamics: A shift away from high-valued tech giants towards a more diversified portfolio could mitigate risks associated with overconcentration in the Magnificent Seven.
• Investment Strategy: Emphasizing defensive sectors and maintaining balanced exposure to AI leaders can position portfolios for long-term resilience amidst market uncertainties.
• Infrastructure Challenges: Addressing the power consumption bottleneck is crucial for sustainable AI growth, necessitating innovative solutions beyond incremental fixes.

For investors, navigating the AI landscape requires a blend of cautious optimism, strategic diversification, and a clear-eyed assessment of both technological advancements and infrastructural constraints.