AI Opportunities Beyond Mega-Caps: Insights from Parnassus Investments

The current wave of AI innovation is not solely benefiting the tech behemoths. Lori Keith, Portfolio Manager and Senior Analyst at Parnassus Investments, joined Bloomberg Tech to discuss how investors can find opportunities in the mid-cap segment of the market, identifying companies that are either building the infrastructure for AI or actively integrating AI to boost their productivity and competitive advantage.

The Broadening AI Landscape

Keith highlighted that the focus on a small group of massive technology companies has overshadowed a broader field of opportunities. She noted that the value chain for AI extends beyond compute and memory players into critical areas like water and power, which are essential for supporting the growth of AI and data centers. These less obvious sectors, often found in the mid-cap arena, present attractive investment prospects.

The full discussion can be found on Bloomberg Technology's YouTube channel.

Drawing an analogy to the rapid adoption of high bandwidth memory (HBM) in server design, Keith suggested that similar trends are emerging in power and water infrastructure. The increasing demand for data centers, coupled with the need for modernized grids and a transition to diverse power sources, creates significant opportunities for companies providing these essential services. The scarcity of water and the requirements for its treatment in chip manufacturing and data center cooling also present compelling investment cases.

Mid-Caps Offer Diversity and Value

Keith pointed out the significant difference in market concentration between large-cap and mid-cap stocks. While approximately 40% of the large-cap index is dominated by just 10 companies, the largest constituent in the mid-cap segment represents only about 70 to 80 basis points. This dispersion offers a wider array of opportunities. Furthermore, Keith highlighted a valuation advantage for mid-caps, which trade at around 17 times earnings, compared to large-caps at nearly 21 times and small-caps at 25 times. This makes mid-caps an attractive proposition relative to their earnings growth prospects.

The sector composition also differs, allowing investors to diversify away from more crowded trades. Many mid-cap opportunities benefit from AI as an enhancement rather than being solely dependent on it, providing a more resilient investment thesis.

Case Studies: Hubbell and Robinhood

As an example of a company benefiting from the AI build-out, Keith cited Hubbell, a leading provider of equipment for the electrical grid. She explained that the need to modernize the grid, support diverse power sources, and meet the increased power demands from data centers creates a strong opportunity for Hubbell. The company's existing business is being enhanced by these trends.

On the user side, Keith pointed to companies like Robinhood Markets Inc. (NASDAQ:HOOD) as examples of entities leveraging AI to improve business outcomes. Robinhood is reportedly using AI to power about 75% of its customer service calls, leading to tangible benefits and improved competitive advantages. Keith anticipates a long tail for AI adoption by enterprises, extending beyond customer service and engineering into areas that drive margins.

Western Digital as a Key Enabler

Addressing Western Digital Corp. (NASDAQ:WDC), which has been a strong performer, Keith acknowledged its role as a key enabler in the AI space. The increasing demand for storage driven by AI and the massive amounts of data generated by AI models provide a long secular tail for companies like Western Digital. She noted that the company has been a long-term holding and continues to offer significant growth potential.