The emergence of Generative Artificial Intelligence (AI) has created a rush of interest from investors hoping to capitalize on the long-term growth opportunity. Emerging markets—characterized by higher longer-term growth, fast evolving application scenarios, and lower IT spending as a percentage of gross domestic product—offer unique opportunities and challenges for investors seeking exposure to Generative AI. A robust and rapidly developing ecosystem of hardware and software companies may not only dominate this space in emerging markets but also rival players in the developed world.
The extensive data size and complexity of large language models (LLMs) require a high-specification, high-cost AI infrastructure. For example, based on industry estimates, an AI training server can cost 15 times more than a general server. Like companies that provided the “picks and shovels” during the 1840s gold rush, companies that have exposure to the hardware supply chain of AI in emerging markets are among the early beneficiaries of the AI boom driven by surging interest in the supply chain. Indeed, like the gold mining industry, having a robust infrastructure in place is a prerequisite for any successful mining operations. Emerging markets have quality hardware companies that can capitalize on these opportunities.
Meanwhile, software and internet companies in emerging markets can be likened to gold miners. These companies develop the algorithms, software platforms, and applications that extract value and insights from the vast amounts of available data. Despite being just as integral to the emerging markets AI ecosystem as the hardware players, the software sector’s year-to-date share price rally has been comparatively lackluster. These software “gold miners” must navigate an emerging market landscape with regulatory, geopolitical, and technological challenges to “strike gold” (i.e., monetize their investment in AI).
The two events called out in the chart are key recent announcements of new AI applications in the west (ChatGPT) and in China (Ernie Bot). They are for reference only. The MSCI EM Semiconductors and Semiconductor Equipment Index and the MSCI EM Software and Services Index are free-float equity weighted indexes composed of stocks across 24 emerging market (EM) countries. All securities these indexes are classified in the Semiconductors and Semiconductor Equipment Industry Group or the Software and Services Industry Group (within the Information Technology sector) according to the Global Industry Classification Standard (GICS®). You cannot invest directly in an index. Past performance is not a reliable indicator of future results.
Emerging market software and internet companies are at an earlier stage of commercialization of AI Generated Content (AIGC) versus their developed market peers and face more challenges in regulation and procurement of innovative hardware. However, we believe these challenges are reflected in their current valuations, leading them to trade lower than our estimates of their longer-term intrinsic value. As AI continues to grow, we expect leaders to emerge. The sector is worth watching closely because, unlike the actual gold mining industry, where gold miners are constrained by reserves in the ground, the “gold miners” in the AI industry have the potential to operate recurring revenue models that provide a more predictable and stable income stream, resulting in higher value over the life of the investment.
Within our emerging market coverage, we see an increasing number of software and internet companies developing both fundamental LLMs and application layers (using third-party LLMs). On the demand side, despite weak IT spending pickup year to date, we are seeing strong customer interest at business and consumer levels, especially on trailing AIGC services with a strong pipeline of products and demos to be released in the second half of 2023. Moreover, these companies are coming off a lower base in terms of monetization metrics such as user paying ratio, percentage of recurring revenues, and average revenue per user, which implies a longer runway for growth. Emerging markets, which are characterized by higher longer-term growth and evolving market needs, have software and internet companies that can implement, adapt, and upgrade their AI solutions on top of their core functions. These companies can use pricing strategies to drive revenue and earnings growth with government and institutional support providing additional tailwinds.
In sum, we see hardware, software, and internet companies as being integral to the emerging market AI ecosystem with the software and internet companies trading at potentially attractive valuations. By building a balanced mix of these companies at the portfolio level, we can capture the shorter- and longer-term opportunities along the value chain in various aspects of the emerging market AI industry.
Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further nredistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.