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Optimism is an admirable human trait, especially in a world that often seems entirely devoid of hope. But when it comes to investing, that emotion can get you into troubling positions. As a proponent of renewable energy, I am optimistic about the potential of humanity's sustainable future. But I would be negligent if I allowed those feelings to translate into a portfolio filled with speculative solar, wind power and electric vehicle stocks.
So, in the world of investing, a healthy does of pessimism is sometimes a necessary evil. And when it comes to finding pure-play artificial intelligence (AI) stocks, that is precisely how I feel.
The Problem With Nascent Industries' Stocks
When it comes to finding industry dominators — well-established companies that have proven their worth and have exploded in market capitalization — it is much easier to find them in industries that have been established for decades or longer.
Take, for example, energy. If you like the sector's potential in the near, medium or long term, you could not go wrong with owning shares of oil majors like Exxon Mobil Corp . ( NYSE: XOM ) or ConocoPhillips ( NYSE: COP ). The former has been around since 1870, and the latter was established in 1875. Both call oil-rich Houston home, and both are so well-rooted in the sector. They have also rewarded shareholders with sizable, growing dividends and massive share appreciation over the past +150 years.
The same goes for tech. If investors are drawn towards Magnificent Seven-style companies that promise unchartered growth potential, they can't go wrong with Microsoft Corporation ( NASDAQ: MSFT ), Amazon ( NASDAQ: AMZN ) or Alphabet Inc . ( NASDAQ: GOOGL ).
But these are examples of companies that have been operating in their respective industries for decades if not well over a century, having established themselves as leaders that have aggressively expanded through mergers and acquisitions over time. And that is precisely the issue with AI and its pure-play stocks, which operate in a burgeoning space with fierce competition for market share and incredibly high burn rates inhibiting their individual profitability. That is why — for now — I am bearish on stocks operating exclusively in that space, and why I believe the following three stocks should not be owned.
No. 1: C3.ai Inc.
With a ticker symbol like it has, one would be led to believe that C3.ai Inc . ( NYSE: AI ) is the end-all be-all of AI-leveraged stocks. Unfortunately, that could not be further from the truth. Founded in 2009, the company went public in late 2020. And when it did, its price per share surged to $161. However, at the time writing, shares are trading for just $30.43, representing an -81.10% loss from the stock's all-time high. So where did C3.ai go wrong? Perhaps it bit off more than it could chew.
The company's bread and butter is enterprise AI, which is the integration of AI-enabled technologies and techniques for large organizations, which allows them to enhance business functions and increase efficiency. That is, in a nutshell, what C3.ai creates for other companies and institutions. Examples of the company's clientele include the U.S. Air Force, Shell Plc ( NYSE: SHEL ) and major Fortune 500 utility companies. On paper, C3.ai has a dream team of customers. But on actual paper — that is financial statements — it is an entirely different story.
According to the company's May 29, 2024, supplemental investor report, it grew its subscription revenue 41% over the prior quarter, which has translated to 20% overall revenue growth and the resultant $19 million in free cash flow. Positive cash flow is a good indicator of financial wellbeing for companies. But it is also just the first time in the past four quarters the company has been able to achieve that feat, posting free cash flow losses of -$45.14 million, -$53.88 million and -$7.40 million in the prior three quarters.
Then there is operating income, which is a company's profit after making operating expenses deductions for costs associated with daily operations, wages and salaries, taxes and interest paid on debt. For the trailing 12 months, C3.ai showed operating income of -$318.34 million — a figure that represents a nearly 10% increase from the same period in 2023 and a 62% increase from the same period in 2022. The result: Earnings per share (EPS) for the most recently ended quarter was -11 cents on $86.59 million in revenue.
For that reason, analysts are being conservative about the company's ability to turn a profit for itself and for shareholders. The Wall Street Journal gives C3.ai a median one-year price target $29.50, a high-end price target of $40 and a low-end price target of $15.
No. 2: Baidu Inc.
Baidu Inc . ( NASDAQ: BIDU ) is a Chinese multinational technology company. The Beijing-based firm specializes in internet-related services, including cloud computing, big data and AI services. Baidu has over 39,800 employees and boasts a market cap of $30.80 billion. However, shares of its stock are down -8% over the past month, -24% so far this year and -39% over the past year.
Despite posting an EPS of $2.74 in the most recent quarter and soundly beating revenue forecasts since the first quarter of 2022, the company ended 2023 with net debt of ¥11.91 billion, or $1.64 billion in U.S. dollars. Worse yet, its trailing 12 months of operating expenses were $1.52 billion, representing a 64% increase from fiscal year 2023. As a result, Morningstar analysts estimate that Baidu will see tempered revenue growth of 1% for each of the remaining two quarters in 2024, or 2% for the full year, based on industry headwinds.
Then there are regulatory concerns. As a company operating in China, Baidu faces more regulation than other pure-play AI companies. According to MIT Technology Review, in June 2023, the country's "top governing body released a list of legislation the were working on [and] an 'Artificial Intelligence Law' appeared for the first time, and experts expect that law to start impacting the industry in the second half of 2024, affording the government "more control over how AI disrupts (or doesn't disrupt) the way things work today." In short, the law aims to dictate what AI companies should steer clear of, which may have broad interpretations and inhibit future growth.
Nonetheless, the Wall Street Journal's analysts give the stock a median one-year price target of $140.55, with a high-end target of $181.76 and a low-end target of $81.94. At the time of writing, shares of BIDU are trading for $87.94. But given the competition the company's facing while managing skyrocketing operating expenses, growth could be slower than expected, which could hinder the stock's ability to achieve consensus price targets.
No. 3: Darktrace Plc
Why would a company whose shares are up nearly 84% over the past six month make my list? Because I believe the stock is overvalued. Darktrace Plc (OTC: DRKTF) is a British cybersecurity firm established in 2013 and headquartered in Cambridge, England. The company's stock has seen tremendous share appreciation this year, going from a year-to-date low of $4.11 in early January to $7.56 at the time of writing.
Darktrace is a member of the FTSE 100 Index, the United Kingdom's best-known stock market index made up of its 100 highest market cap companies. And like the other two firms on today's list, Darktrace is a pure-play AI stock given its AI Research Centre, which focuses on integrating AI technology to bolster cybersecurity initiatives. According to the company's website, it has "approximately 160 patents and patents pending," with more than 200 research and development personnel, of which roughly 100 hold master's degrees and 20 have obtained doctorates in disciplines ranging from astrophysics and linguistics to data science. Darktrace's Attack Path Modeling (APM) module is exploring how real-time, automated, dual-aspect multi-data source APM can be used to give teams a comprehensive view of realistic, risk-prioritized attack paths so that resources can be best allocated to defend key assets.
And it seems to be working for the company, which has accrued a $4.09 billion market cap. In June 2023, its posted free cash flow of $107.93 million on $548.10 million in revenue. Its revenue, by the way, has grown exponentially since 2019:
- 2019: $137.02 million
- 2020: $199.08 million
- 2021: $281.34 million
- 2022: $417.15 million
- 2023: $548.10 million
That is good for an astounding 300% increase in just five years and has translated into earnings success. Darktrace has beaten EPS estimates in four of the last five quarters. On its balance sheet, total liabilities have been far outpaced by growth in total assets. So why am I bearish on a company that is beginning to establish a track record of earnings beats while growing its revenue and assets while not significantly increasing its liabilities? Three reasons: (1) its price-to-earnings (P/E) ratio, (2) its past stock price and (3) its trading volume.
First, Darktrace's P/E ratio is too high for my liking at 45. For context, the average P/E ratio of a company in the S&P 500 is between 20 and 25. And while its P/E ratio is not astronomical, it suggest that at its current share price, it could be overvalued. Second, the share price itself. While $7.56 does not seem too elevated, it is coming off of an 84% gain this year and historically, the stock remains well off its all-time high of $12.60 achieved on Oct. 20, 2021. That represents a 40% decrease from its record high. Third, the stock's trading volume remains incredibly low. During its most recent run-up on April 26, 20224, which saw shares climb to around where they are trading today, volume spiked but still only reached 342 million. The company's average daily trading volume (ADTV) is 1.33 million. By comparison, Tesla Inc. ( NASDAQ: TSLA ) has an an ADTV of 156 million.
But don't just take my word for it. Analysts at the Wall Street Journal agree. Their median one-year price target for Darktrace is $7.77, or just a 2.7% gain from current prices. On the high end, analysts give it a $7.92 price target while on the low end, the price target goes in at $7.72. That is uninspiring when you consider that pure-play AI stocks are supposed to represent enormous growth potential.
The Bottom Line
Returning to the point about optimism and investing, if you do find yourself bullish on AI in general, the safer and more logical way to invest in the industry is through AI exchange-traded funds (ETFs) that can offer you braod exposure while minimizing the risks you could face. Discovering pure-play AI stocks that seem poised for tremendous upside is like finding a needle in a haystack.
ETFs that hold a basket of stocks leveraged to AI may be the better option, as may enormous Big Tech companies that may not be pure plays but do allocate and reinvest significant funds into developing their AI capabilities. The aforementioned companies Microsoft and Amazon.com come to mind.
No matter what you decide, giving your portfolio at least some exposure to AI is not a terrible idea. History tends to repeat itself, and using the dot-com bubble as example could provide some insight. That bubble may have burst in early March 2000, but investors made fortunes in its run-up by getting in on tech stocks early. And just like then, there will be companies that survive if and when AI inflates to the point of bursting.
Remember to always conduct your own due diligence before entering any trade.
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