Will 'old' companies prove to be the biggest AI winners?

Excitement over the potential of AI has driven much of the appreciation in global markets in recent years, with the ‘Magnificent 7’ megacap US tech stocks leading the charge: Amazon, Alphabet (Google), Meta (Facebook), Microsoft, Nvidia, Apple and Tesla. Their dominance experienced a setback in April as investors sold down US tech stocks after the US announced its new tariff regime. However, as tariff fears eased, US tech came roaring back. Questions are now re-emerging over whether the Mag 7 can justify their valuations and whether AI can live up to its potential.

Aziz Hamzaogullari is the Founder, Chief Investment Officer and Portfolio Manager of the Loomis Sayles Growth Equity Strategy Team. He is a long-term investor in six of the Mag 7 – excluding only Apple. In this Q&A we asked Aziz for his current take on AI and whether he is backing his mega-cap tech portfolio holdings to continue to beat expectations in future.

Question: Three of the companies in your portfolio, Microsoft, Amazon and Alphabet, seem to be at the forefront of bringing AI functionality to others. What is it about these ‘old’ companies that enables them to remain cutting edge and competitive for so long?

Aziz Hamzaogullari: What we have seen in the past is that whenever there’s a new technology or disruption, people tend to proclaim that these ‘old’ companies are dead. What they often overlook is the power these companies wield through their capital and innovation. If you look at the so-called Magnificent Seven, they account for more than 40% of the total R&D spend among the top 1,000 companies in the US. This means that the top seven are spending $40 out of every $100 allocated for research and development in the US, while the remaining 993 companies are spending just $60.

These companies are investing a large portion of their sales into innovation. However, sheer dollar amounts alone do not guarantee success. They also have very large customer bases and they understand what their customers' need. Then they invest in meeting in those needs, extending their business models and developing commercial solutions before other companies are able to do so. In terms of capital expenditure, the top seven companies account for 25% of the total capex in the United States. When you combine innovation and capex, with their installed base and understanding of technology, and large R&D budgets - this is the foundation of why these firms continue to dominate.

Take a company like Meta, which started as Facebook. I had so many meetings where people would tell me that their family and friends hated Facebook. Yet since its IPO, Meta has expanded its user base from 800 million to 3 billion plus users and has developed multiple successful products, including WhatsApp and Reels which each boast over a billion users. Similarly, Alphabet created YouTube, which is the world’s biggest streaming platform alongside Netflix. If YouTube were a standalone company, its valuation would be significant.

Amazon was initially viewed as just an e-commerce company, a book retailer. When we invested in Amazon in 2006, many research reports focused on competition from Borders and other book retailers, missing the larger point. Jeff Bezos articulated this vision in his first letter when he stated that they were targeting the entire retail market, which was valued at $18 trillion back then - today, it’s around $28 to $30 trillion. Moreover, Amazon evolved from being a pure e-commerce company to providing Amazon Web Services (AWS). They transformed a cost centre into a profit centre, leveraging their internal operations to offer services to third parties. Now, they are expanding into logistics, which has significant implications for companies like UPS. We sold our holding in UPS years ago once we recognised that Amazon was entering this space. This year UPS is cutting about 20,000 employees, 4% of its global workforce, as Amazon has now started delivering its own packages and now potentially has a larger delivery network than both FedEx and UPS combined. And now, Amazon is getting into advertising, they have a $60 billion business in advertising, bigger than many dedicated advertising companies.

These companies are innovation engines, and I think people underestimate the persistence of their growth.

Question: The emergence of China's new AI-powered chatbot app, DeepSeek, triggered a flurry of investor concerns for AI-related companies. You are an investor in Nvidia, does the emergence of DeepSeek undermine the investment thesis for Nvidia?

Aziz Hamzaogullari: DeepSeek has emerged as an innovative offering from China, however it's crucial to note that there are several questions around DeepSeek. Even if we assume that everything they say is accurate, and they are being truthful about not having used more advanced chips, it does not alter the conclusion that they are solving a problem that had already been solved, cheaper. AI was already a very progressive field that was continuously evolving and compounding and cheaper solutions were happening anyway.

More importantly, we need to follow the money. The biggest spenders on AI are our other holdings, such as Meta, Alphabet, and Microsoft. These are very rational people making rational decisions on their spending. The reality is that these companies will continue to invest significantly in AI because they are already receiving a considerable return on their investments. For example, in 2022, there was much concern about what TikTok and short-form video content would mean for the industry. However, thanks to Meta’s investments and expertise in AI they have found great success in short-form video with their ‘Reels’ feature.

This chart from McKinsey estimates AI's impact on the global economy.

AI's potential impact on the global economy, $ trillion

Source: The economic potential of Generative AI: The Next Productivity Frontier. McKinsey & Company, June 2023

If we look back to the year 2000, during the tech bubble, one surprising development, at the time, was the productivity gains from these new technologies. Alan Greenspan (economist and former chair of the US Federal Reserve) often commented on this, how challenging it was for the Federal Reserve to predict and they were consistently surprised to the upside. We believe that AI will have a similar impact, with estimates suggesting a total benefit to companies in the range of $18 to $25 trillion due to productivity improvements. We have already seeing this, before DeepSeek and ChatGPT, with numerous papers highlighting effective AI applications and productivity gains in fields like medicine and finance.

That said, this doesn’t mean that Nvidia will never go down more than 20%. Take Amazon, for instance, which we have owned for 19 years. Its stock dropped by 20% or more on 14 separate occasions during that time. Such fluctuations do not make Amazon a poor company; rather, they illustrate the market's reaction to various disruptions. Only 57 managers out of ~9,500 owned Amazon for the entire 19 years, as many sold their shares during those corrections.

When considering companies like Nvidia, at the end of the day you need to take a step back and ask: ‘What is the opportunity this company is addressing and what do they bring to the table and can someone else replicate what they do?” We believe that Nvidia possesses a very formidable set of competitive advantages, including their CUDA programming platform. Nvidia operates more as a software company than a chip manufacturer, and their network of developers is very difficult to replicate and they are way ahead of their competitors. Amazon and Google are two of their largest customers and even though they both have internal solutions, they continue to use Nvidia's technology, as they are receiving substantial benefits from doing so.

Question: Meta is one of your top holdings, and it remains a stock that investors are very interested in. What are your current thoughts on Meta?

Aziz Hamzaogullari: I think Meta, even after all the appreciation, remains a compelling investment. Remember that in 2022, it was the worst performing stock in our portfolio during a time of significant controversy. One major issue was when Apple changed its privacy settings, making it much more difficult for Meta to target consumers based on data. This conflict arose because Apple demanded a substantial portion of revenue, to which Mark Zuckerberg responded, "No, thank you." Instead, they chose to absorb a $10 billion hit in the short term and innovate around this issue, which they successfully did.

There were also concerns about the shift to video format, akin to the transition we saw during the company's IPO from desktop to mobile. Our focus has always been on the key competitive advantages that Meta possesses. First and foremost, they have over 3 billion customers.

To put that into perspective, if you want to reach that number of consumers through any other medium, it's practically impossible. Even if you could do that, say through TV or outdoor advertising, it would be prohibitively expensive. Also, for small businesses—like gyms, personal trainers, barbers, or photographers—spending a few hundred dollars on advertising can generate thousands in revenue. There is no other medium where businesses can effectively reach their target consumers like they can through Meta. Despite the ongoing debate about potential competitors disrupting Meta, many overlook the extensive network of 3 billion consumers and tens of millions of advertisers that depend on Meta to generate revenue.

When we consider the advertising landscape overall, we're looking at about $2 trillion spent globally, excluding China, with online advertising still representing only a quarter of that total. Consumer time spent online is significantly higher than time spent in other mediums, indicating that there remains a substantial gap between time spent and dollars spent.

Furthermore, because of the limited supply of advertising real estate on screens, advertisers bid for that space. When Meta is reaching consumers through phones, iPads, or other screens, there is a distinct supply and demand dynamic. Advertisers compete to pay for that digital land, giving Meta tremendous pricing power. Over the past decade, this pricing power has contributed significantly to revenue growth,

In addition to this, Meta is experiencing volume growth due to the ongoing expansion of online advertising. We believe they hold significant competitive advantages and are well-positioned to benefit from advancements in AI. In fact, their AI models are likely among the most advanced available, even compared to other offerings like ChatGPT. They recently introduced a new model, further solidifying their position in the market.

In summary, we see a long runway for Meta's profitable growth, which is why it remains a significant holding in our portfolio.

Question: Moving on to Tesla, what are the risks to Tesla's brand and sales if Elon Musk continues to alienate a substantial portion of potential customers?

Aziz Hamzaogullari: I'm glad you asked this question. There have been concerns regarding Tesla, particularly about potential brand damage and whether there could be a structural impact on the long-term fortunes of the business due to Elon Musk's association with the brand. During times of anxiety and controversy, it can be challenging to gauge the true value of a company. However, I want to remind everyone that, despite this correction, Tesla has performed very well recently. In the final quarter of 2024 it was up between 60-80%, and even though it's down so far this year, it remains the number one performer in our Large Cap Growth strategy on a one-year basis.

Fundamentally, we believe that Tesla is better off with Elon Musk than without him. He is the driving force behind Tesla, responsible for the creation of the brand and all its innovations, from the Model Y to the Model S. Even if the political landscape were different and there were no controversies surrounding Musk, the results in Q1 would likely have been similar because the company is undergoing a significant transition with the introduction of the new Model Y.

This transition involves changes across their factories in the US, Europe, and China, as they shift production lines from old models to the new ones. This is not a new issue; they have been discussing it for months. While some people may choose not to buy a Tesla because they don’t like Elon Musk, we have seen similar situations with leaders of other companies, such as Mark Zuckerberg at Meta, Bill Gates at Microsoft, and Larry Ellison at Oracle. In all of those cases, and now in this case, we remove emotion from decision-making and focus on the money.

When we follow the money, we see that the Model Y was the number one selling vehicle model of any type in 2023 and 2024, selling 1.2 million and 1.1 million vehicles respectively. The only competitor with similar scale is BYD, which has a much lower price point. As a result, while Tesla sold about one quarter of the units of BYD it captured a significantly larger portion of the dollar value of the EV market.

What we like about Tesla is that, even if you had time and capital, it would be very, very difficult to replicate its business. Manufacturing an electric vehicle is more about software than hardware, necessitating the vertical integration that Tesla has achieved. One of Tesla's biggest achievements has been this end-to-end manufacturing process, which traditional manufacturers struggle to replicate.

We have observed that traditional auto manufacturers are facing what we call the "innovator's dilemma." They are dealing with the same issue that traditional retailers experienced when Amazon came onto the scene. These manufacturers are burdened by their extensive cost structures while trying to compete with a new, leaner cost model. Most of them have failed - some went bankrupt, while others have lost significant market share as they tried to catch up with Amazon.

Our analysis indicates that traditional auto manufacturers are falling behind. We have tracked their plans over the past ten years, and these plans have continually been pushed back. Meanwhile, Tesla is gaining significant market share.

Tesla has also transformed its distribution model, selling directly to consumers rather than through dealerships. Additionally, they have developed software that serves as a key competitive advantage, particularly with their Full Self-Driving (FSD) capabilities. Furthermore, Tesla is changing its business model. They treat their cars like printers—selling the hardware while generating ongoing revenue through software subscriptions and updates. This approach creates substantial profits from the growing installed base of cars.

While there may be some impact on the brand due to Musk's actions, we believe that Tesla remains a superior product. Metrics of brand loyalty indicate that it is a great brand capable of sustaining itself. Lastly, we believe Elon Musk is a smart individual. Much like Mark Zuckerberg, who adjusted spending strategies in response to controversy around the Metaverse, Musk has a vested interest in the success of Tesla as its largest individual shareholder. We are already seeing signs that he is distancing himself from government initiatives to focus more on Tesla.