Catching the Artificial Intelligence Boom Requires Smart Stock Picking

As artificial intelligence explodes in popularity, so too are investment opportunities. But to spot some promising stocks requires a bit of "intelligent" searching.

We all know early winners have so far been Nvidia (NVDA)  and Microsoft (MSFT) . Nvidia's chips provide the necessary processing power for AI, while Microsoft has integrated ChatGPT into Bing search. But another type of company should directly benefit from the AI boom: those who manufacture the sophisticated equipment required to build these chips.

Applied Materials (AMAT) is the best-positioned company in the sector. AMAT is especially attractive to investors, too, because of its reasonable valuation.

AMAT recently unveiled a new manufacturing method that aims to reduce the need for extreme ultraviolet lithography, or EUV lithography, which is used in the process of making some types of chips. The Centura Sculpta tool, developed over six years, is a breakthrough in patterning that can save money by reducing patterning complexities that consume time, energy, materials and water. AMAT estimates capital expenditure savings of $250 million per month per 100 thousand wafer starts of production capacity, with each wafer costing $50 less, requiring 15 fewer kilowatts of energy, and needing 15 fewer liters of water. While adoption of the tool will take time, it has already been embraced by Intel (INTC)  as the production tool of record for multiple layers. Reduced spending by chipmakers on lithography could potentially have a minor effect on ASML Holdings (ASML) , the leader in the field, over the long run.

The tool's impact on AMAT's business may be more incremental than blockbuster, only adding as much as 5% to revenues by 2025. Yet, it exemplifies what great companies do: innovate to improve efficiencies, expand market reach, and deepen customer relationships.

The recently passed CHIPS and Science Act, which channels over $50 billion to the semiconductor industry to produce chips in the U.S., is expected to drive strength in the semi cap equipment sector over the next few years. Major fabrication plants by Intel, Taiwan Semi (TSM) , and Samsung are in the works in Ohio, Arizona, and Texas, respectively. Other nations intent on reducing reliance on Taiwan have also subsidized the reshoring of chip production.

The semiconductor sector is set to rebound after a cyclical downturn caused by double ordering and an unsustainable surge in pandemic electronics buying. Powering the next upturn includes the mainstreaming of AI, autonomous driving, electric vehicles, video gaming, and augmented and virtual reality. The underlying stocks are already anticipating some resurgence in demand, with the SMH up almost 20% after a dismal 2022, when it was down 35%. Economic concerns about a potential upcoming recession -- and fears over the extent of yield curve inversion -- could produce market weakness and a buying opportunity at lower levels.

AMAT is one of the most balanced semiconductor capital equipment makers, with the broadest product portfolio and a top position in several billion-dollar categories. The equipment maker has now made further inroads into developing the most complex AI-related chips. With a reasonable valuation at around 16-times earnings per share and over 90% of its free cash flow allocated toward buybacks and dividends -- retiring over 20% out outstanding shares over the last six years -- AMAT is one of the top semi stocks to accumulate on weakness.

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At the time of publication, Ginesin was long AMAT, long MSFT short MSFT calls