Why AI disruption favours value investors

AI driven volatility is reshaping markets and creating one of the most compelling investment backdrops in recent years, reminiscent of the Covid 19 period. Alex Wright, portfolio manager of Fidelity Special Values PLC, outlines how he believes AI led disruption is driving widespread dislocation across sectors, creating selective opportunities that increasingly favour value investors.

Valuations critical in this uncertain AI environment

The emergence of generative AI has injected a new level of uncertainty into markets. The technology is clearly transformational and will redefine industries and business models over the very long term. But it’s extremely difficult to ascertain the exact impact over the next ten years.

That uncertainty matters for valuations. Companies trading on rich multiples leave little margin for error. When investors assume a company’s monopoly advantage will endure, even a modest shift in competitive dynamics, including the risk of AI-driven disruption, can justify a meaningful de-rating. We have seen this dynamic in information services and software businesses, where valuations have rightly fallen from very high levels. However, in most cases they still remain expensive, although there are areas of opportunity. Generally, the outlook for many industries is less predictable and businesses regarded as having unassailable moats or monopoly positions may not enjoy the same dominance in future.

We avoid companies where their stretched valuations rely on long-term certainty. Instead, we focus on attractively valued businesses where the market has overreacted to perceived AI threats and where balance sheets provide strong downside support. The low valuation multiples we pay for stocks means we do not need to take a decisive view on the outlook beyond the next ten years. We also look for cheap underappreciated beneficiaries - companies with genuine exposure to structural change that the market has yet to fully recognise, such as outsourcing company Mitie, which supports the design and delivery of data centres. Integrated utility company SSE also benefits from AI-related growth through higher need for electric grids and renewable energy demands.

AI-dislocation opportunities – staffing companies, wealth managers and others

Over the past six months, we have increased our exposure to staffing companies (Page Group, Hays and Sthree), which together account for 2.1% of the portfolio. Investors have viewed staffers as vulnerable to disintermediation long before the emergence of AI. More recently, concerns about automation and job displacement have intensified those fears. However, we have yet to see clear evidence that AI has structurally impaired these businesses.

Staffers trade below trough valuations and have been weighed down by a prolonged downturn in staffing activity, driven by cautiousness from corporates and low candidate churn following the Covid-19 pandemic. While the potential long-term impact of AI on staffers remains uncertain, we believe these businesses are adaptable and current challenges appear largely cyclical rather than structural. Interestingly, in the US where AI adoption is most advanced, we are already seeing signs of improvement in staffing activity.

The risk reward profile is very attractive over a three-to-five-year view as valuations reflect significant disruption, while offering substantial upside should a recovery in hiring activity materialise.

More recently, markets have reacted to AI disruption in increasingly irrational ways. Wealth managers are among the latest to be drawn into the sell-off, a sector that’s long endured disintermediation fears from robo-advice and lower-cost alternatives without having meaningful effects.

Our holding in St James Place illustrates how AI-driven volatility is disproportionately affecting a business and creating investment opportunities.

Excitement remains despite market’s all-time highs

As a contrarian investor, I usually grow more cautious when markets reach all-time highs. Yet this time there’s a different dynamic, as beneath the surface there are many divergences in performance and exciting new ideas. Last year’s strong performance was largely due to our large-cap exposure, but our ~60% exposure to mid and small-cap companies was generally a performance headwind.

We are beginning to see early signs of an economic inflection, particularly across industrial and consumer-facing sectors that have faced a prolonged period of weakness. Many of these businesses still trade at depressed valuations despite stabilising or improving fundamentals. At the same time, companies perceived to be sensitive to AI disruption have sold off sharply. Markets have indiscriminately punished anything with even indirect AI exposure, often without clear evidence of structural impairment. Despite headline markets hitting-all time highs, I believe it’s an attractive hunting ground for contrarian investment opportunities.