Artificial intelligence (AI) has triggered the share price surge of Nvidia as chips from the company better known for processing computer game graphics become the gold standard to power AI applications. Various other companies plugged into the AI supply chain and ecosystem are tagging along for a ride as well. These range from manufacturers of the chips to operators of data centres and application developers. Companies that stand to benefit include those providing security services.
“When you have innovation, you have new vulnerabilities and you have to offset these new vulnerabilities with new security solutions. At present, we have AI, a big, massive, disruptive technology, which will certainly drive new security solutions,” says Yves Kramer, senior investment manager, thematic equities, at Pictet Asset Management. “AI will work if we protect it. Without proper protection, the potential risks can be significant,” says Kramer in an interview with The Edge Singapore.
Kramer is the founding portfolio manager of Pictet’s security strategy, managing AUM (assets under management) of some US$5.8 billion ($7.9 billion), making it one of the largest funds investing across various global value chains of safety and security.
Kramer has a very wide range of stocks to pick for the fund. Security is pervasive, encompassing the whole range from electronic payments to biometric security systems to food safety. “The beauty of this universe lies in its inherent diversification benefit, it enables us to strategically allocate our portfolio based on areas of growth,” he says.
Kramer recalls that some years back, the self-driving car was the stuff of “science fiction”. Currently, more companies are showcasing their versions of self-driving cars. When more of these cars take to the road, security systems will be required.
Similarly with the growth of electronic payment systems where cards, terminals and entire networks have to be secured. The need for security pervades across other critical everyday areas such as energy, healthcare and IT services. The three broadly defined markets: IT security, security services and physical security constitute a US$500 billion market.
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AI boost
This figure is set to grow further as AI becomes more prevalent. While AI as a technology has been talked about for decades, it was only in the last couple of years that large language learning models was able to refine programming code and develop that human language interaction with computers that is now possible. Unsurprisingly, investors, sensing the potential transformative effects and business opportunities, are following the trend closely. From Kramer’s perspective, the tech world is just at the beginning of adopting the use of AI in a significant way.
However, before AI applications can be deployed and used in a big way, there is a need to build up the infrastructure, which ranges from networks to servers housed in data centres. The market potential is huge. For data centres, which sit on the infrastructure side of the booming AI universe, there is a growing need for capacity as more companies shift their workload from on-premise to the cloud as part of the wider shift. As big companies aim to run their large language models to better customise their respective advantages in AI, there will be additional demand for data centre capacities.
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As not all companies are yet willing to commit to build and operate their own data centres, which takes time and significant capex, the preferred model is to rent space from data centre operators. “From the data centres’ perspective, you have an imbalance demand between supply and demand, which means data-centre companies have some pricing power. It is a good business to invest in,” says Kramer.
Another interesting trait of this entire market for security is that the different players do not compete head-on with each other but within specific niches. For example, within cybersecurity, there are network security companies like Palo Alto Networks, Checkpoint Software and Fortinet; in the area of identity cybersecurity, there is Okta, among others; while yet many others specialise in database or fund transfer protection.
Despite the stiff competition, it is not easy for users to switch from one provider to another as this comes with its own cost. While rivals can compete on pricing, the cost of migrating from one cybersecurity solution to another can be very high as users need to remove all the software from pretty much everywhere to redeploy the new solution, cost of exit, says Kramer.
Paying the right price
Security providers enjoy another advantage. “By definition, the entire technology landscape is deflationary. However, it is less true for the security industry is seen as a must-have rather than a nice-to-have,” says Kramer, referring to how users are willing to pay for the latest features to protect their systems and ward off potential threats.
Another trait of the broader tech stocks universe is that they tend to be more volatile than stocks of other sectors such as utilities, real estate and industrials. Kramer explains that Pictet maintains an investment thesis that helps manage that volatility. If a particular stock is more volatile, Pictet will reduce the weighting within the fund. If it is less volatile, the stock can have a higher weightage within the portfolio.
Using traditional valuation methods, many of these security stocks are assigned lofty valuations of triple-digit times earnings, drawing inevitable comparisons to stocks in the dotcom mania of more than two decades ago. Kramer points out that many dotcom companies were not making much money, if at all as investors were betting on growth expectations six or seven years down the road. In contrast, today’s tech companies, even those in niche areas, are profitable and are already generating cash flow in their own way to support growth.
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Still, there is a key metric that measures how companies are moving along nicely that makes investors like Kramer happy to own their stocks: sales. “As an investor, you are willing to sacrifice a portion of earnings in favour of allocating resources towards sales and marketing investments. This strategic approach has to drive rapid sales growth and market share growth,” he reasons.
The valuations can also be partly justified by the revenue model many of these companies adopt, a subscription-based model where customers who sign up pay a regular fee for a fixed term.
Just as how subscription-based models work well for dominant software providers like Microsoft with its suite of office productivity applications, the same model works well for cybersecurity providers too as they provide a lot of cash flow visibility.
Besides visibility, companies also receive constant feedback from their clients, on what functionalities the would like to have, and how existing software should be updated, which encourages customers to stay on longer as their feedback is valued, further improving revenue visibility.
Last but not least, the universe of security stocks, given their high growth potential, is set to benefit like most equities when interest rates do come down. “We are more focused on mid and large caps. If you think interest rates will go down it should generate significant performance. That’s where we do differentiate,” says Kramer.
