J Studio
Profit expectations for AI companies are slipping, which may come as a surprise to many growth investors who have enjoyed robust gains since October 2023. Indeed, tech and momentum companies have underpinned the bull market for several quarters, but we may be in the early stages of a transition into higher-value, cyclical sectors in global stock markets.
Following the Virtus Artificial Intelligence & Technology Opportunities Fund's (NYSE:AIO) 30% total return, I am downgrading the fund from a “buy” to a “hold.” The fund's valuation is even more expensive today following lower earnings expectations as the seasonal bearish trend continues.
It will be key to see how AI, growth tech and other momentum stocks perform after NVIDIA (NVDA) reports quarterly earnings next week. For now, I am remaining cautious.
AI companies will withstand EPS downgrades
BofA Global Research
According to the issuer, AIO aims to generate a stable stream of income and capital growth by focusing on one of the most significant long-term growth opportunities in the market today. It employs a multi-asset approach based on fundamental research and dynamically allocates to attractive segments of corporate debt and equity to provide an attractive risk/return profile. The fund will typically invest at least 80% of its net assets (including borrowings for investment purposes) in a combination of securities issued by artificial intelligence companies and other companies positioned to benefit from opportunities in AI and other technologies.
AIO's assets under management have grown from approximately $680 million at the date of my last analysis last winter to more than $745 million today. The expense ratio is quite high at 1.41%, but since this closed-end fund frequently uses leverage to target large gains, the high expense ratio is not a major concern to me. Currently, the total effective leverage as of July 31, 2024 is 15.0%.
Moreover, share price momentum has been strong throughout the year. Moreover, income investors are likely to be attracted by AIO's high forward yield of 8.4%. Finally, liquidity metrics are uncertain. Virtus Partners does not list the CEF's 30-day median bid-ask spread, and the average daily trading volume is only 116,000 shares. Therefore, we recommend using limit orders during the trading day.
Taking a closer look at the portfolio, the Morningstar 4-star ETF is heavily weighted towards large caps and growth, meaning performance will be heavily influenced by the major themes permeating the market. If the AI bubble ever does pop, AIO will likely underperform. The fund's price-to-earnings multiple has increased by around 3x since my last report, and given that EPS growth is expected to slow over the coming year, AIO is clearly overvalued.
AIO: Portfolios and Factor Profiles
Morning Star
While yield-hungry investors may like the current dividend rate, AIO is a fund for growth-oriented investors. By sector, nearly half of the portfolio is in the information technology sector, while the remaining 20% is high-growth healthcare companies, including the hugely successful Eli Lilly (LLY).
Value positions are small, with financials accounting for 13% of AIOs, and industrials, energy, and materials accounting for less than 2% each.
AIO: Holdings and Dividend Information
Find Alpha
One of the reasons I argue for a downgrade is the fact that AIO has finished in the red in each of the last five Septembers. While seasonality is said to be secondary to fundamentals and price movements, this metric should not be taken lightly these days.
AIO: The dreaded September seasonality
Stock Chart
Technical insight
While I have doubts about the valuation and macro situation for AIO's portfolio, the company's technical situation is favorable. Notice in the chart below that the stock broke out of the important $19-20 range a while ago. This rally suggests a projected rally to around $25 based on the $5 high of the previous range, a target I mentioned back in February of last year. However, the stock has traded low at $22 over the last month, causing AIO to fall back down to its rising long-term 200-day moving average.
This indicator is trending up, suggesting that bulls have control of the primary trend. Additionally, look at the RSI Momentum Oscillator at the top of the chart. It is hovering between 30 and 80, which is healthy without any significant dips into oversold conditions. Finally, the $16-20 price range has seen heavy trading volume, which could provide a significant cushion for the downside if we see a prolonged pullback.
Overall, AIO trends are solid.
AIO: Bullish uptrend with strong RSI momentum
Stock Chart
Conclusion
I have a Hold rating on AIO. The stock has risen significantly since Q1 due to the strong AI theme and notable momentum alpha. I believe the company is overvalued given the declining revenue growth trends for AI-related companies.
