When it comes to the production of artificial intelligence (AI) chips, Nvidia(NASDAQ: NVDA) has a big lead over the competition. By most estimates, the company has an 80% to 95% market share for AI graphics processing units (GPUs).
However, because the company’s shares trade at 36 times sales, Nvidia’s stock price will be very sensitive to competitive pressure. And by one measure, that competitive pressure could come sooner than expected.
When it comes to cutting-edge AI stocks like Nvidia, monitoring research and development (R&D) spending is a must. Research and development expenditures help investors estimate how much a company is investing in innovation. Often these expenses will not pay off for years, but neglecting this crucial area of investment can prevent a company from maintaining its competitive advantages in the long term.
At this point, there’s no doubt that Nvidia has a huge competitive advantage when it comes to AI GPUs. The company generates gross margins of approximately 75%, while competitors do as well Intel And AMDonly manage gross margins between 40% and 50% – a strong sign of Nvidia’s pricing power.
Nvidia also doesn’t trade higher prices for lower volumes. Nearly every market estimate points to the company having a controlling market share for AI GPUs.
There’s just one problem: Nvidia appears to be underinvesting in research and development just as its lead in AI GPUs is growing to dominant proportions. Intel spends billions more annually on research and development, despite a 95% smaller market cap. Even AMD has higher research and development expenses as a percentage of its revenue.
I worry that Nvidia is sacrificing future growth by not spending more on research and development.
NVDA R&D to Revenue (TTM) chart
Here’s the basic truth about investing in chip stocks like Nvidia: This sector is terribly cyclical. In 2022, valuations of virtually every chip maker – including Nvidia – fell by double digits, even as long-term volumes continued to rise. In 2023, the sector’s valuation rose across the board.
However, something interesting happened in 2024. Nvidia’s stock price continued to skyrocket, while AMD’s valuation remained flat and Intel actually did lost about a third of its value.
The past few years have not been atypical. Every year the semiconductor sector brings new challenges and opportunities, with valuations and market shares shifting dramatically due to new innovations and growth categories. But there’s no doubt about what the biggest growth driver will be in the next decade or more: AI.
Right now, Nvidia’s GPUs are the best option for almost every AI developer — so much so that companies are willing to pay significantly more for Nvidia chips than for competing options. That’s great news for Nvidia, considering it’s dealing with rising volumes and rising pricing power just as spending on AI infrastructure is rising.
But as with previous chip wars, the competition is getting fiercer. Intel is investing billions in its Gaudi 3 and Falcon Shores chips, which recently showed comparable performance to Nvidia’s H100 models. And AMD’s MI325X chip, launching later this year, can handle most AI applications currently in development. Meanwhile, a host of private startups, such as Cerebras and SambaNova, are taking unique approaches to AI GPUs that could ultimately make Nvidia’s current approach obsolete.
While Nvidia’s lead and pricing power won’t disappear overnight, increasing competitive pressure (and rivals’ R&D spending) leads me to one simple investment strategy: don’t put all your eggs in one basket. Most investors betting on Nvidia today are betting on the increase in AI spending, and not necessarily on Nvidia’s ability to maintain its competitive advantages in the long term.
If that includes you, don’t be afraid to invest some of your capital in out-of-favor chip stocks, like Intel and AMD, that are spending billions to support future launches that may be years away . Even if 90% of your AI investment is focused on Nvidia, diversifying your portfolio with other chipmakers ensures that wherever the competition turns, you’re positioned to take advantage of the rising demand for AI, one of the greatest growth opportunities so far this century.
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Ryan Vanzo has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends Advanced Micro Devices and Nvidia. The Motley Fool recommends Intel and recommends the following options: Short November 2024 $24 Calls on Intel. The Motley Fool has a disclosure policy.
Should Nvidia investors be nervous about this red flag? was originally published by The Motley Fool
