For investment purposes, there are several choices for those who have been passively watching the rapid developments around artificial intelligence last year and are now wondering how to play the market. Some may opt for the popular ARK Autonomous Technology and Robotics ETF (ARKQ) managed by the flamboyant Cathie Wood. Less popular in terms of the number of followers on Seeking Alpha and not holding big names like Tesla (NASDAQ:TSLA), the Robo Global Robotics and Automation Index ETF (NYSEARCA:NYSEARCA:ROBO) has proved less volatile than ARKQ in the last two years as charted below.
However, with a performance of -22.5%, it is still in negative territory, and, my objective with this thesis is to show that it is the right investment vehicle to profit from the commercialization of AI, in a macroeconomic context that continues to be characterized by uncertainty as interest rates remain high while the Federal Reserve has signaled that it will stick with the 2% inflation target which could mean fewer rate cuts this year than the market expects.
First, it is important to show why investing in AI-related stocks still makes sense in 2024.
The Investment Case for AI and Robotics
Coming back to the above chart, I deliberately included two years, as 2022 was marked by the Federal Reserve tightening monetary policy at an unprecedentedly aggressive pace (in recent times) and 2023 was the year that ChatGPT provided millions throughout the world with a glimpse of the opportunities made possible with AI. Subsequently, about 5% of enterprises adopted intelligent systems.
Then, logically you would expect 2024 to be the year of widespread adoption as the benefits of innovation expand from those contributing to building AI infrastructures like Microsoft (NASDAQ:MSFT) and Nvidia (NASDAQ:NVDA), to those using the technology to enhance the quality of products they design and manufacture. In other words, after 2023 being the year of initiation, 2024 should be marked by commercialization with AI possibly disrupting every industry across the board. For this matter, as per researchers at Oppenheimer Generative AI (or Gen AI) “could upend every sector”.
Looking deeper, the adoption of AI is being helped by LLMs (large language models) that make applications like ChatGPT become multimodal or hear and see, instead of being restricted to writing text. Hence, integrating other modalities such as voice, images, and video, enables LLMs to provide a better understanding of the data in a bid to improve comprehensiveness. An example is AI not only restricted to generating textual reports but also used to construct the accompanying images and videos.
Now, translating these capabilities to the industrial space, just imagine how robots that have been around for years but still require a long time to be programmed to have a conversation can now be easily “fitted” with the chat feature of generative AI. This implies that intelligent software can make robots or other related devices more interactive by establishing a two-way communication process between the user and the machine.
Talking applications, commercial use cases span from the life sciences tools industry including Azenta (AZTA), Intuitive Surgical (ISRG), and Illumina (ILMN) which form part of ROBO’s first twenty holdings as shown below.
Looking further, companies like Rockwell Automation (ROK) should benefit as the increased prevalence of AI in industrial applications not only accelerates automation but also allows the U.S. manufacturer to compete better with low-cost producers. Looking further, there is robotics manufacturer Fanuc Corp (OTCPK:OTCPK:FANUY), and Keyence Corp (OTCPK:OTCPK:KYCCF) which specializes in industrial machinery. Both are based in Japan.
Consequently, commercialization opportunities should allow the ETF’s holdings to increase sales in turn benefiting ROBO.
Valuing ROBO Using Realism
In this context, the global generative AI market size is projected to grow at a CAGR of 47.5% from 2023 to reach $667.96 billion by 2030. Furthermore, about 50% of this market consists of the manufacturing and healthcare industries, which are well represented by ROBO’s holding as detailed above. This means that the ETF could potentially grow at 23.75% (47.5/2) CAGR, but, being realistic, AI has already been around for years as exemplified by big data and analytics which can analyze vast data sets to extract valuable information for decision-making purposes. One example is to recommend a gearbox change for a factory robot after analyzing millions of data points as a preventive measure. Moreover, there are developments like machine learning that have already been embedded into devices and robots to enable them to have a higher degree of automation.
Therefore, in light of the above, I further divide the 23.75% above into two, resulting in around 12% as an annual revenue growth opportunity. I use the same figure for the upside I estimate for ROBO in 2024. This translates into a target of $60.76 (54.25 x 1.1) based on the current share price of $54.25.
I further justify this target given ROBO’s lower Price/Earnings of 23.06x which trades at an 18.7% discount relative to ARKQ’s 28.38x. The Robotics ETF also trades at a discount of 7% relative to the Nasdaq-100 tracking Invesco QQQ Trust ETF, in a way showing how its holdings have been relatively underinvested as investors focused on the Magnificent 7 group including big names like Apple (AAPL), Microsoft (MSFT), Nvidia, Tesla, Alphabet (GOOG), Meta Platforms (META) and Amazon (AMZN).
Adding some caution, according to JP Morgan (JPM), there should be a “backlash” in driverless cars this year. This is based on issues faced when testing autonomous cars in real-world conditions. Examples are vehicles blocking ambulances and other emergency responders and even causing accidents involving casualties.
As a result, companies offering exposure to autonomous vehicle technologies like Luminar Technologies (LAZR) as encircled in red in the above picture have seen their stocks dip by more than 35% during the last year. Other Lidar-based automotive companies have suffered more like Cepton (CPTN) which plunged by over 76% during the last year, but it does not form part of ROBO’s holdings. Scanning through the entire list of holdings, I did not see other names forming part of the LIDAR basket which means that the effect of a backlash, if it occurs will be much more mitigated for this ETF.
Looking at Concentration Risks
Moreover, with only 17.7% of its overall weight constituted by its first ten holdings as per the table below, ROBO carries fewer concentration risks compared to its peers. Furthermore, it has delivered a one-month performance of 2.98% while ARKQ has lost over 1%. On top, it has also outperformed QQQ which could be due to investors rotating out from the Magnificent 7 to adopt a broader market investment approach.
Thinking aloud, ROBO’s equal-weighted strategy could make sense in an increasingly volatile market. As such, the economy continues to grow and add jobs as shown in the December report on January 5 prompting both equity and treasury bonds to go down possibly in anticipation of interest rates remaining higher for longer. Eventually, the market recovered, this time due to lower-than-expected December ISM Services PMI indicating lower expansion of the services sector both in terms of new orders and employment. This volatile scenario triggered by contradicting figures can be repeated as the market remains data-driven and the current 3.1% inflation rate remains high given the Fed’s stringent 2% target.
Also, with assets under management of over 1.3 billion, ROBO charges an expense ratio of 0.95% which may seem relatively high, but the reason is its equal-weighted approach whereby its top holding makes up for around 2% of total assets. As such, more work is required from the asset managers who have to continuously amend the weighing structure. This includes continuously selling shares of a holding whose stock has appreciated and reallocating the proceeds to underweight ones.
ROBO Is a Buy as Gen AI Renders Robots More Interactive
Therefore, with less concentration risks, ROBO appears more appropriate to invest in transformative AI innovation and robotics this year, and, especially after the volatility which marked the performance of tech stocks in the first week of January. Moreover, for those who have been holding to the ETF for the last two years, it could more than recoup its two-year losses of 22.5% with an additional 12% potentially added to its 14.66% one-year performance. However, with uncertainty about a rate cut in March, expect general market volatility to linger on, especially for the next two months while the soft landing vs recession debate gets hotter.
Still, I am bullish, mainly based on the assumption that we have now reached the commercialization phase of AI, which should positively impact innovation and robotics. In this case, previous flavors of artificial intelligence lacked the human touch of Generative AI which can better understand the intent of queries by learning the context, as evidenced by the answers provided by ChatGPT. On top, there is also the conversational feature whereby someone can chat with the system thereby contributing to better interactivity. Hence, the next wave of innovation may come more from industrial applications around the home, companionship, and also in transportation, but, again, in the name of caution, I raise the alarm around things like autonomous vehicles.
Finally, after 2023 has focused on the enablers of Generative AI, this bullish case is based on 2024 likely to be favorable to stocks that can now apply intelligent systems to deliver enhanced products like robots to businesses and consumers. To this end, ROBO is the right ETF to invest in the secular digital transformation trend now driven by AI, with this year’s price performance likely to continue being impacted by volatility associated with the monetary policy path.