Three areas stand out in the current market: cloud computing giants, aerospace aftermarket firms, and AI infrastructure.
Cloud Computing Giants
Microsoft (MSFT), Amazon (AMZN), and Google/Alphabet (GOOGL) are compelling stocks. Their valuations have drifted down over the past year. Investor sentiment swings - one month these look like AI winners, six months later the view has turned. Through all of it, revenue growth keeps speeding up. Valuations keep getting more appealing. The margin drop that investors feared from AI a couple of years ago never happened. Margins are actually rising at Amazon (AMZN) and Google (GOOGL).
Custom silicon matters a lot to the long-term economics of AI for all three. These companies run huge volumes of customer workloads in their data centers. Some workloads are very demanding and need the top Nvidia (NVDA) chips. Others are more standard and run well on the companies' own custom chips, which are more specialized and less general-purpose. A mix of both is key for each firm. Custom chips are designed in-house, so they carry higher margins - a main reason Amazon (AMZN) and Google (GOOGL) margins perform so well. Microsoft's (MSFT) chip program is earlier in its rollout; margin gains should come from it over the next couple of years as it deploys more widely.
These companies win whether open-source or closed-source models lead. OpenAI and Anthropic are two private firms with the leading closed-source models, and investors are very excited about them. One risk is that open-source models - far cheaper and easier to customize - catch up to closed models. Over the past six months, open-source models have closed ground on the most capable OpenAI and Anthropic models. But the cloud giants earn revenue from usage and consumption on their platforms. They charge less per task for open-source models than for closed ones. Still, many extra services like security and database ride along with open-source use, so profitability for the two is similar for these big data center operators. They are happy to shift customers to the cheaper, more customized open-source products. This ties to Nvidia's (NVDA) acquisition of Hugging Face.
Aerospace Aftermarket
Aerospace has struggled. The ITA ETF is down more than 10% over the last month and up only 3% year-to-date. The market is focused on two risks. First, the war with Iran and its effect on oil prices. Second, Boeing (BA) raising its production rate. Both are seen as risks for aftermarket businesses like TransDigm (TDG), GE Aerospace (GE), and Heico (HEI).
These stocks look increasingly attractive. Valuations have become more appealing as the stocks underperformed this year. They are not underperforming because earnings estimates are falling, results are weak, or revenues are dropping - the opposite is true in every case. Investors fear higher oil prices will push airlines to cut flight schedules, meaning less demand for aftermarket services. They also fear that Boeing (BA) building more new planes means less wear and tear on older ones.
What investors are missing: all planes are in use today, and Boeing's (BA) higher output will serve new routes and flight tracks for airlines worldwide. Demand for aftermarket services is durable. These companies should keep growing above the GDP rate. They also have pricing power, because aerospace has heavy part-by-part regulation, making it hard for airlines to switch from one supplier to another. Several are allocating capital in shareholder-friendly ways. GE (GE) announced a decent-sized acquisition of a key supplier. TransDigm (TDG) has been acquiring over the last couple of years, including recent months, and so has Heico (HEI).
TransDigm (TDG) stands out. The business is growing double digits organically. Its margin has been rising lately, so profits grow even faster than revenue. Valuation has come down after the stock materially underperformed over the last year, and it now trades at an attractive level. Its capital allocation is very shareholder-friendly: when it cannot find good acquisition targets, it pays special dividends or buys back stock. It has been buying back stock recently. In the past, TransDigm (TDG) buybacks signaled the stock was cheap, and shares did very well over the following year or two. We are in one of those periods now, making it a compelling buy.
AI Infrastructure
Investing with the most high-quality, established companies is the right way to play the AI infrastructure build-out now. We are in year three or four of what should be a long cycle, but there will be ups and downs and digestion periods.
Appealing names include Nvidia (NVDA), Broadcom (AVGO), Eaton (ETN) on the electrical equipment side, and Applied Materials (AMAT), a semi-cap equipment company. Many data center CapEx beneficiaries are outstanding. A lot of these stocks underperformed over the last couple of months after the all-time rally in the second quarter. This process looks like it is bottoming out now.
OpenAI's Astra model, introduced last week, shifted the market's focus. It feels like a return to the second-quarter environment, where data center CapEx stocks did well and software, SaaS, and disruption-feared companies suffered - including intermediary brokerage firms in commercial real estate and insurance, and Thomson Reuters (TRI). Those names are weakening again, and that may continue as we build toward Anthropic's IPO in a month or two.
The full list of quality names: Nvidia (NVDA), Broadcom (AVGO), Applied Materials (AMAT), Eaton (ETN), Amazon (AMZN), Google (GOOGL), Microsoft (MSFT), and Meta (META). Orion Energy Systems (OESX), a small lighting company, is also benefiting from the build-out.
