ARTIFICIAL INTELLIGENCE INVESTMENT IMPLICATIONS

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1 ARTIFICIAL INTELLIGENCE INVESTMENT IMPLICATIONS 1

2 Michael Halloran, CFA ARTIFICIAL INTELLIGENCE INVESTMENT IMPLICATIONS July 16, 2018 While artificial intelligence has been around for over 50 years and has always generated excitement, we think it is still in the early innings of a golden age. This piece reviews the field of artificial intelligence and presents related investment ideas. Advanced data analytics and artificial intelligence (AI) have demonstrated significant potential for transforming business models and disrupting industries. This is producing winners and losers and has significant investment implications. While every sector of the economy is being impacted, we see the benefits far outweighing the disruptions. Advanced data analytics and AI are driving needed productivity gains, which are essential for raising economic growth potential and living standards. Artificial Intelligence Defined: Artificial intelligence is the development of computer systems that are able to perform tasks that normally require human intelligence, such as visual perception, speech recognition, decision-making, and translation between languages. AI is different from traditional software programs in that it extracts knowledge from data and can alter its behavior (or learns) without specifically being programmed, i.e. machine learning. Think of Uber s self-driving cars for visual perception, Apple s Siri and Amazon s Alexa for speech recognition, and IBM s question answering computer system, Watson, that won Jeopardy!, and can process the equivalent of a million books per second. While today s uses are compelling, they barely scratch the surface of the potential applications of this technology. Recent AI Advances: Big data (and the ability to access it), computing power, and advances in algorithms are all catalysts for artificial intelligence advancement - with most recent advances being achieved by applying machine learning to very large data sets. The proliferation of smart phones and smart devices, coupled with a high-speed internet, are producing massive amounts of data that is well suited for AI applications and analysis. Digitization of most business and personal records is also a catalyst. Cloud computing - using a network of remote servers hosted on the Internet to store and manage data, rather than a local server or a personal computer - is providing convenient access to large amounts of data that can be readily analyzed via AI. Major internet firms and many other industry leading firms create, or have access to, large data sets that can be analyzed by their own AI experts or by third party experts that they hire (a major restraint for the AI market is the limited number of AI technology experts). Computing power continues to make major advances so that computations that were unthinkable in the past are now routine. All of this has combined to produce a fertile background for advanced analytics and AI advancements in all sectors of the economy. Machine Learning Provides Predictions and Prescriptions Focus of Machine Learning Types of Analytics (in order of increasing complexity): Descriptive Predictive Prescriptive - Describe what happened. - Anticipate what will happen (inherently probabilistic). - Provide recommendations on what to do to achieve goals. - Employed heavily across all industries. - Employed in data-driven organizations as a key source of insight. - Employed heavily by leading data and internet companies. Focus of Machine Learning Source: Janney ISG, McKinsey Global Institute 2

3 Explosive Growth of AI Investment: IDC (a technology market intelligence provider) forecasts spending on AIfocused hardware, software, and services to reach $58bn by 2021, up from ~$12bn in 2017, making this one of the fastest-growing technology segments (growing at nearly 50% CAGR). Artificial Intelligence (AI) Potential to Create Value across Sectors In addition, McKinsey Global Institute, a leading think tank for corporate America, estimates that AI techniques have the potential to create between $3.5 trillion and $5.8 trillion in value annually across many economic sectors (see chart). This constitutes about 40 percent of the overall $9.5 trillion to $15.4 trillion annual impact that could potentially be enabled by all analytical techniques. Productivity and Global Prosperity: Deployment of AI and automation technologies can do much to lift the Source: Janney ISG, McKinsey Global Institute global economy and increase global prosperity, at a time when aging and falling birth rates are acting as a drag on growth. Labor productivity growth, a key driver of economic growth, has slowed in many economies, dropping to an average of 0.5 percent recently from 2.4 percent a decade earlier in the United States and major European economies, in the aftermath of the 2008 financial crisis after a previous productivity boom had waned. AI and automation have the potential to reverse this decline. Estimates show productivity growth could potentially reach 2 percent annually over the next decade, with 60 percent of this increase from digital opportunities. Overblown Job Loss/Replacement Concerns: Just like the invention of the steam engine and farming automation did not eliminate the need for workers, AI will not eliminate the need. However, some activities are more automatable than others, including physical activities in highly predictable and structured environments, as well as data collection and data processing. While nearly all occupations will be affected by automation, most workers from welders to mortgage brokers to CEOs will work alongside rapidly evolving machines. The nature of these occupations will likely change as a result. Meanwhile, a major concern for the U.S. economy is a lack of qualified workers that has resulted in a record 6.5 million job openings today. AI and its productivity benefits will help alleviate these concerns. Many Economic Sectors Benefit from Advanced Data Analytics and AI: While the technology sector is obviously a very important AI player, many other industries are potential beneficiaries. 3

4 Industry Artificial Intelligence Application Internet Internet companies (like Google, Amazon, Facebook), as pure digital entities, have taken the lead in both generating big data and utilizing AI to analyze big data. Software & Information Technology Many of these firms (Microsoft, Adobe, Salesforce, Accenture) are well positioned to capture future technology Services spending that needs to take place by all industries. Banking and Finance Automated trading & investment, trading strategies, robo-advisors, voice-based commerce, customer behavior analysis, chatbots for customer services, identity verification, and fraud detection. Insurance Claims management and fraud detection, analyzing customer behavior and reducing revenue churn, automated underwriting, pricing, conversational platforms for customer services, complying with regulations, and trading strategies. Health Care Diagnostics, image analytics for early disease detection, drug discovery, patient monitoring (pre-emptive warning systems), personalized medicine and treatment. Media & Communications Customer analytics, forecasting and customer demand trends, video analytics, computer vision interactivity (e.g. in video games and other immersive media). Manufacturing and Natural Resources Predictive maintenance, machine learning driven insights for yield improvement, optimization. Retailing Customer analytics, forecasting, anticipating demand trends, reducing revenue churn, supply chain management, warehouse automation, chatbots for customer services, conversational commerce. Supply Chain Management Warehouse automation, inventory management based on insights gleaned from demand analytics, autonomous delivery. Transportation Self-driving vehicles, Advanced driver assistance systems, personalized content delivery / productivity enhancement tools used by providers of transportation services. Utilities Enhanced supply-demand management based on AI-driven analytics, predictive maintenance, dynamic pricing based on consumption analytics (provided by smart meters, for example), chatbots for customer service. Government Smart surveillance, threat detection, Smart Cities and Utilities, AI-enhanced and personalized education and training, chatbots for information distribution and citizen engagement. Source: Janney ISG, Gartner, Capgemini. Companies well positioned for success with advanced data analytics and artificial intelligence share similar attributes: 1. A willingness to embrace digital transformation. Across industries, companies addressing their own digital transformation are well positioned to be the leaders in the adoption of AI. The pure digital companies have already shown leadership in using AI (Google, Amazon, Uber, Netflix, etc.), and the faster other industries digitize, the faster they can take advantage of the insights and efficiencies of AI. 2. Industry bellwether firms with access to large amounts of industry and customer data, and a demonstrated ability to capitalize on technological advances. Many AI success stories involve industry dominant firms that have a history of technological innovation and strive to maintain their technological edge. 3. Firms that generate significant cash flow that can fund future technology investments. Competition for AI talent is fierce and technological transformation can require significant investment. 4

5 The following table lists industry-leading companies with a history of successful technology investment. They are making significant use of, and investments in, advanced data analytics and AI. While AI plays a bigger role in some of these firms, it is an important component to the future of all the listed firms. Stock (Ticker) Apple (AAPL) Alphabet (GOOGL) Amazon (AMZN) Facebook (FB) NVIDIA (NVDA) Johnson & Johnson (JNJ) J.P. Morgan (JPM) Chevron (CVX) Rockwell Automation (ROK) United Health Group (UNH) Industry Forward P/E Div Yield % Comments Consumer Apple just hired Google s chief of search and artificial intelligence (considered a major coup). Technology Apple also holds a dominant industry position with access to lots of customer data through their devices, store, and cloud. Apple generates lots of cash flow to make the necessary AI investments. Consumer Google s mission is to organize the world s information and make it universally accessible and Technology useful with AI playing a major role. Google is the dominant force in online search and advertising and is well positioned to make future investments. Retailing Along with dominating online retailing, Amazon has become a force in AI, which is integral to Amazon s products - from Alexa, to product recommendations, and Amazon Web Services (AWS). Amazon has lots of data and is willing and able to make future investments. Consumer Technology AI is critically important to Facebook - from generating personal recommendations to its messenger chatbots. They use AI for screening fake accounts and removing problem imagery, hate speech and fake news. Facebook has lots of customer data and cash to fund AI investments. Technology NVIDIA is the leading AI semiconductor chip manufacturer with applications in automotive, robotics, construction and mining, healthcare, and other industries. NVIDIA is investing heavily in AI and gaining market share. Healthcare J&J is using AI to revolutionize healthcare. AI is speeding up the drug discovery process, robotizing surgery, and being used to create products that monitor and make patient recommendations. Finance JP Morgan has a team of 40,000 technologists with a tech budget of $10.8 billion with $5 billion set aside for new projects. Their recently hired head of AI was head of machine learning at Carnegie Mellon University (widely considered the preeminent institution in the field), showing they are serious about AI. This financial bellwether also has lots of customer data. Energy The oil & gas industry generates massive data that is well suited for AI. AI is being used to sift through seismic data for reducing dry wells, optimize drilling and production, predict maintenance and avoid failure, and survey and inspect. Industrials Smart manufacturing requires the use of new and disruptive technologies such as AI to create the future industrial plants and supply networks that are flexible, efficient, responsive, and secure. Rockwell is the factory automation leader, serving many industries across the globe, and is making major AI investments. Healthcare United Health works with a massive healthcare data base and is using AI to help solve our healthcare cost problem. They are using AI and advanced analytics to help organizations reduce operating costs and improve the quality of care, while managing the cost of care. They are the managed care bellwether, with one of the largest groups of data scientists in health care analytics, and are making major investments. Disclaimer: The Janney Artificial Intelligence Investment Opportunities report is being provided solely for informational and illustrative purposes, is not an offer to sell or a solicitation of an offer to buy the securities highlighted in the list, and does not constitute investment advice by Janney Montgomery Scott LLC or its affiliates. The securities referenced in this report do not refer, and should not be taken as referring, to an actual fund, portfolio or account, and should not be deemed as a model investment portfolio. Decisions to buy or sell a stock should be based on an investor s investment objectives and risk tolerance and this material should not be relied upon in substitution of independent judgment. This material does not take into account individual client circumstances, objectives or needs and is not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. 5

6 This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis. 6