AIO: This CEF Is Not Only Looking For 'Pure-Play' Artificial Intelligence Software Names

Summary

• We anticipate that artificial intelligence will play a crucial part in the further digitization of companies in all industries.
• 4 out of the top 10 holdings consist of major semiconductor companies.
• Approximately 50% of total assets are invested in equities, while the rest are invested in convertibles, preferred stocks, and bonds.

Photo by Peshkova/iStock via Getty Images

In this article, we would like to present to our readers Virtus AllianzGI Artificial Intelligence & Technology Opportunities Fund (AIO), which was incorporated less than 2 years ago. The portfolio management team has stated in the prospectus that it is looking to benefit from any kind of new disruptive technologies as well as new developments in the artificial intelligence space. In the post-pandemic environment, we believe that artificial intelligence will be able to minimize the risk of any kind of future global pandemics. In addition, it will make organizations leaner and more efficient as it will be able to make sense of a large amount of data businesses capture from their customers, vendors, employees, competitors, etc. Customers will also benefit as well, as we will be able to enjoy personalized and more sophisticated products and services that are essential in our daily lives. Therefore we believe that secular trends of artificial intelligence will remain strong over the next decade. This is one of the key reasons why we find this CEF appropriate for long-term investors who are looking to have mixed exposure to both convertible securities and equities within the IT industry. In addition, AIO offers a forward distribution yield of 5.48%, which is quite a decent yield for a tech-related fund. In general, tech companies offer very low dividend yields or no dividends at all.

Portfolio Construction

Artificial intelligence is a disruptive market by its nature. Therefore an excellent selection of key holdings will be of crucial importance for the future performance of this CEF. For instance, if we take as an example a company like Zoom (ZM), which has been able to disrupt the online communication services over a very short period of time during the outbreak of the COVID-19 pandemic. Before the pandemic, we were all already familiar with products like Skype (MSFT), Google Hangouts (GOOG), and Facebook Messenger (FB) for online collaboration. Nonetheless, Zoom was able to become an essential tool for remote work and learning and we believe a similar thing can happen in the artificial intelligence market. A smaller company can disrupt the largest-tech companies thus leading to a significant market share expansion. However, large-tech names have inevitable financial and human capital resources to bring similar kinds of solutions to the market, thus minimizing the disruptive force of a smaller company. As soon as Zoom was able to gain noticeable exposure, Microsoft was able to release its Microsoft Teams product, which uses similar features as Zoom. Our readers should keep in mind that IT departments of major companies use bundles of products from a single mega-tech company like Google and Microsoft. If we buy hundreds of products and solutions from various providers, we might face complex integration challenges as well as higher licensing fees.

(Source: Monthly Holding)

Therefore, we like the fact that this CEF has exposure in the range of 1.2 % - 2.2 % to the top 10 holdings, which make up approximately 16% of total holdings. Our readers should keep in mind that even though the portfolio manager of this CEF labels this fund as Artificial intelligence, it also uses equities or convertible securities of companies that might have disruptive power in other new technologies. Therefore, a better pick to gain exposure to the artificial intelligence sector might be well-known ETFs like BOTZ or ROBO. We were quite surprised when we noticed Deere (DE) as the largest holding of this CEF, despite the fact it is not an IT company or has anything to do with disruptive innovations in the artificial intelligence space. Major manufacturing companies have been investing heavily over the last decade into IoT devices, artificial intelligence, automated production facilities to improve their productivity and quality of manufacturing processes. John Deere released a press release a couple of days ago that it has been able to develop a new AI solution with Intel (INTC) to optimize the welding process in real-time.

"Welding is a complicated process. This AI solution has the potential to help us produce our high-quality machines more efficiently than before. The introduction of new technology into manufacturing is opening up new opportunities and changing the way we think about some processes that haven't changed in years."

-Andy Benko, quality director, John Deere Construction & Forestry Division

(Source: Intel Newsroom)

It is not only down to manufacturing processes that John Deere has been testing Artificial Intelligence capabilities but also in the field of digitalization of agriculture. Precision AG has basically enabled farmers to work remotely and use the newest technological solutions with the help of big data analysis and AI capabilities to optimize and automate their farming operations like field prep, seed planting, and harvesting.

Unfortunately, the company does not report separate quarterly or annual revenue for its Precision AG segment. It reports it as a combined Production & Precision Ag segment, which was approximately $3.07 billion in Q1 21 or up 22% y/y. John Deere's management has provided even more visibility during the most recent earnings call on how a mix of its integrated digital solutions and machinery can bring value to customers and lead to higher revenue over the long run.

"I think what is happening there, when you think about not just price, but what's happening with price and mix, is we're continuing to see average selling prices of our Large Ag machinery growing and that's through the continued integration of technology and solutions into that business."

(Source: John Deere Earnings Call Q1 21)

Another very interesting exposure of this CEF is to the semiconductor industry. In fact, 4 out of the top 10 holdings are the following major semiconductor players - NXP Semiconductor (NXPI), Broadcom (AVGO), ON Semiconductor (ON), and Micron (MU). Now, our readers might begin to question why we would want to have such a high exposure to semiconductor companies, when in fact we want to invest within the artificial intelligence space. In general, we believe that investors would be better off investing in companies that are selling gold mining equipment rather than buying actual gold miners. The same can be applied to the artificial intelligence industry, as we do not know which software company might be able to disrupt our future with a new service or product. However, we are quite sure that a particular disruptor will need semiconductor chips to run their products or services. Therefore, we believe that it is a very intelligent move by the portfolio management team to construct this CEF with such a high share of semiconductor companies. Over the last couple of years, there has been a very strong demand for semiconductor chips by companies developing artificial intelligence.

(Source: McKinsey)

According to the figure above, the estimated size of the artificial intelligence semiconductor market is expected to almost quadruple from $17 billion in 2017 to $65 billion in 2025. This does not come as a surprise, as a major semiconductor player like Micron has highlighted a very strong demand for memory and storage chips driven by artificial intelligence.

"Following last quarter's introduction of 176-layer NAND into volume production, in FQ2, we began volume production on our 1-alpha DRAM node, solidifying our technology leadership in both DRAM and NAND. We are in an excellent position to capitalize on the strong demand for memory and storage, driven by artificial intelligence and 5G across the data center, the intelligent edge, and user devices."

(Source: Micron Q1 21 Earnings Transcript)

Basically, any software that utilizes artificial intelligence requires a very strong computing power to be able to first store vast amounts of data and then analyze it. In our view, rapid digitalization will continue way after the end of the COVID-19 pandemic, therefore software using artificial intelligence or advanced machine learning will be required in almost every aspect of our daily lives. We have touched on a broader theme of cloud computing and continued digitization in our article analyzing First Trust Cloud Computing ETF (SKYY) here.

We have previously cherished the high exposure to the semiconductor industry of this CEF, but it can end up as a double-edged sword. Despite the fact that McKinsey estimates that roughly 20% of total revenue for semiconductor companies will come from artificial intelligence by 2025, investors in this CEF are still exposed to the remaining 80% of the total revenue of semiconductor companies, which has nothing to do with artificial intelligence. For instance, any potential additional lockdowns due to the COVID-19 pandemic or any other future pandemic might negatively impact the demand for semiconductor chips coming from traditional industries. This will most likely have a negative impact on the total revenue and stock price performance of underlying semiconductor companies thus leading to contracted market return of this CEF. In addition, AIO's portfolio management team might end up with a lower weight than some software companies that are developing artificial intelligence solutions in data analysis or cloud computing. Particular software companies could do well in a prolonged period of restrictive containment measures globally, thus leaving AIO's investors with lower investment returns than expected.

To sum it up, our readers should definitely do their own due diligence and decide if they are willing to hold companies like John Deere or Micron by investing in this CEF or if they should invest directly in an artificial intelligence software company like Nvidia (NVDA). However, our readers should keep in mind that AIO has only slightly less than 50% of total assets in common stocks.

(Source: CEFConnect)

According to the figure above, convertible securities consist of 45% of total assets, while preferred securities and bonds consist of 3.92% and 2.74%, respectively. The portfolio management team has highlighted the strong performance of convertible securities in the semi-annual report for H2 FY 2020.

"Despite historic volatility, convertible securities finished higher over the six-month reporting period, benefiting from strong underlying equity performance and credit spread tightening."

(Source: Fund's sponsor site)

We are uncertain whether the convertible securities will continue with such a strong performance over the next 6-12 months, especially now, when tech stocks have faced quite a volatile month over the last month.

For instance, the largest ETF in the convertible securities universe SPDR Bloomberg Barclays Convertible Securities ETF (CWB), has been able to outperform the broader S&P 500 index (SPY) by slightly less than 21 percentage points, since the end of February 2020.

If we take a look into the market price performance over the last month, CWB has not been able to outperform the broader SPY. In general, indexes tracking the performance of convertible securities have very high exposure to the IT industry, which is also the case with both CWB and our CEF in question AIO. We have consistently provided the following longer-term outlook in our most recent articles, in which we feel bullish about the long-term performance of tech stocks driven by longer-term secular trends of accelerated digitization. On the other hand, we are concerned about the short-term elevated valuations of tech stocks. When it comes down to convertibles, another major part is the interest rate environment. In general, a lower interest rate environment benefits convertible and fixed income securities. That is also something that makes analysts from the global investment management company Schroders feel optimistic about the future performance of convertibles:

"We are constructive about the longer-term market dynamic. There is a huge wave of liquidity and a very clear message from central banks that rates will remain low, quantitative easing will remain high and that they are backing markets."

(Source: Schroders)

Performance

This is one of the few CEFs which we have covered so far that has been able to increase both market price and NAV by approximately 40% since the end of February 2020. We use that time period as the initial outbreak of the global COVID-19 pandemic, which has resulted in the global markets' sell-off in March 2020. Despite the strong performance of this CEF over the last year, we are highly concerned about the volatility of the market price, which could make shorter-term investors quite uncomfortable.

In fact, at the peak point of the global market sell-off in March last year, this CEF was trading at almost a 30% discount to NAV. Well, that places quite a good bargain deal for investors who can spot that investing opportunity. On the other hand, investors who got frightened by sharp market volatility and choppy trading sessions on a daily basis could sell assets in this CEF at a 30% discount to NAV. if we would perform such a trading strategy to buy CEFs at a discount or premium to NAV at 0% and sell them at a 30% discount to NAV, that could act as very destructive to our overall investment portfolio performance. Nonetheless, this CEF has been trading on average at around 10% discount to NAV, which creates a good entry point for any longer-term investors (more than 10 years) out there.

In terms of relative performance to the broader stock market, AIO has outperformed Nasdaq 100 composite index and S&P 500 index by approximately 10 percentage points and 29 percentage points, respectively, since February 22, 2020. This comes as a bit of a surprise to us given that this CEF has almost 50% of total assets in convertible securities. The latter should be in general less volatile and move by lower percentage points compared to general common stocks. Nonetheless, it seems like the portfolio management team has done an excellent job in individual stock selections.

If we compare AIO to other relevant peers in the CEF and ETF universe, then we find out that it has performed quite in line with both the most famous artificial intelligence and robotic ETFs - ROBO Global Robotics and Automation Index ETF (ROBO) and Global X Robotics & Artificial Intelligence ETF (BOTZ) since February 22, 2020. In addition, AIO has been able to outperform the broader IT-related ETF - Technology Select Sector SPDR Fund (XLK) by approximately 13 percentage points during the particular time period. However, one of the largest tech-related CEFs out there, BlackRock Science and Technology Trust (BST), has been able to outperform AIO by approximately 16 percentage points.

Dividends

(Source: Seeking Alpha)

According to the figure above, monthly distributions have been pretty consistent over the last year. AIO has paid its shareholders a monthly distribution in the amount of $0.1083 in the calendar 2020, while shareholders have also been rewarded with a special annual dividend of $1.1558 per share. In addition, particular distributions have been funded by the capital gains or sales of portfolio securities of this CEF so they do not come as a source of return of capital. Another positive news is the fact, a monthly distribution has increased from $0.1083 per share in 2020 to $0.1250 in 2021.

This is the most recent press release regarding the monthly distribution for April 2021:

"Virtus AllianzGI Artificial Intelligence & Technology Opportunities Fund (NYSE: AIO) (the "Fund") declared a distribution of $0.1250 per share to shareholders of record at the close of business on March 11, 2021, payable April 1, 2021. The Fund estimates that approximately 100 percent of the distribution is from profits from the sale of portfolio securities or other capital gains."

(Source: Fund's sponsor site)

Nevertheless, we believe that this CEF will be able to maintain a monthly distribution of $0.1250 per share for the remaining calendar year 2021, as long as interest rates remain at a very low level and tech stocks maintain or even increase their current valuations. Therefore we do not see any kind of imminent risk for the sake of the safety of distributions over the short run. However, we cannot fully neglect any future risks surrounding the COVID-19 pandemic. We believe that financial markets have already priced in the fact that herd immunity might be achieved in developed countries over the next 12-18 months, primarily driven by mass vaccination campaigns. However, we place a higher risk at any kind of new, even more, dangerous strains of the COVID-19 which could make recent vaccines out there ineffective. In addition, even a new, stronger pandemic might occur in the near future as reported by Bill Gates.

"According to the billionaire, "we are not prepared for the next pandemic," in the same way he hopes that this situation will change in a couple of years and indicated the axes of opportunity such as drugs, tests, vaccines, epidemiology, and follow-up.

"This pandemic is bad, but a future pandemic could be 10 times more serious," said the magnate, who urged governments to protect their citizens against possible new diseases."

(Source: Entrepreneur)

In our view, such an event could lead to double-digit declines in major stock market indexes, something similar to what happened in March last year.

Conclusion

We would like to initiate a NEUTRAL outlook for this CEF solely because of its strong overall market price performance over the last 12 months. In addition, AIO has quite a decent exposure to both convertible securities and tech stocks, which have performed exceptionally well during the same time period. The portfolio management team uses a very interesting approach to invest in manufacturing companies like John Deere, which are not well-known tech names but are well-positioned to benefit from the implementation of artificial intelligence in the farming industry. In addition, exposure to semiconductor chips proves that the portfolio management team is not looking for an individual disruptor in the artificial intelligence software but wants to monetize the overall demand for chips being used for artificial intelligence processes. In terms of key risks, we see the following: (1) sharp sale of global tech stocks, (2) narrowing of the outperformance of convertible securities compared to general equities, (3) worsening of the COVID-19 pandemic.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article does not constitute a bid or an invitation to bid for the purchase or sale of the financial instruments in question. Neither is it intended to provide any kind of personal investment advice. Therefore, readers should conduct their own due diligence. Investing in financial instruments may always be associated with risk. Please contact your personal financial or investment advisor for any additional questions or materials regarding this article. We shall not be liable for any type of damage or loss arising from the use of the information contained in this article.