AI Arms Race Creating Investment Opportunities In Select Canadian Sectors

Benjamin A. Smith
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Three Stocks We Like In Canada’s Exciting Artificial Intelligence Space

Artificial intelligence investing is a concept that still breeds confusion within investor circles. Perhaps that’s a byproduct of uncertainty about ultimate technological outcome, monetization capabilities, and fast-shifting product cycles. It’s one of the more difficult sectors to predict because technology changes so rapidly. This article aims to address these complications by narrowing down the must-have AI stocks for your portfolio. 

But before we go there, let’s start with an overarching view of the sector at large.

According to a recently released PWC Moneytree Report, Canadian companies raised $3.3 billion across 333 deals in 2017, compared to $2.2 billion the previous year. Deal activity was down slightly in 2017 (12%), but this was more than offset by a surge in average deal size (31%). Money continues to flow into the sector, despite a tepid Canadian economy only growing at roughly the rate of inflation.

Specifically, the biggest deals were struck in the cybersecurity, digital health care and fintech sectors. That makes sense when you consider the use cases of each category.

Take cybersecurity for instance. Last September’s massive breach of credit monitoring company Equifax Inc. (NYSE:EFX) still reverberates around Corporation Inc. even today. On September 7, the company disclosed on that a massive cybersecurity breach exposed the personal data of 143 million Americans, including 100,000 Canadians. The stock shed nearly 40% in the aftermath, and numerous corporate heads rolled. It’s the type of event every mid/large firm wishes to avoid… at all costs.

Overall, a report funded by IBM figured the average cost of each data breach suffered by 27 Canadian companies in 2016 was $5.78 million, or $255 per lost or stolen record. Of the companies studied, it took firms on average 173 days to identify a breach, and 60 days to contain it. Let that sink in for a moment.

With the arms race between hackers and corporations constantly evolving, cybersecurity isn’t an area which can be neglected. Not when half a billion dollars can vanish in the blink of an eye, as CoinCheck recently found out. If there’s such thing as a recession-proof industry in deep technology, cybersecurity is it. 

Digital health is also a hot commodity. Artificial intelligence is projected to make major inroads in this arena for several reasons.

For starters, the healthcare system is becoming more inefficient over time. Population growth an aging populations are encroaching on the service faster than government can fund it. The net result: more people are managing their well-being, and they’re going online to diagnose and self-administer treatment.

To keep up, AI-algorithms must continue getting ‘smarter’ by bridging the gap between available information and providing useful conclusions patients can use. There is so much information and so many co-factors which can splinter into millions of possible diagnoses. The task is monumental, but not impossible. Billions of dollars are flowing into Canadian companies in order to develop smart interfaces. 

Another factor for sustained AI development in healthcare is accuracy. Simply put, physicians don’t always get diagnoses right.

Now, imagine an AI-platform robust enough to provide a correct diagnosis 98% of the time simply by analyzing saliva and blood samples. Think of the tremendous value that use case would provide. While these advancements are in early-stage development, the science is developing quickly. Already, precise robotic machines are disrupting human surgical intervention in some operating rooms. In a decade, more advanced devices may replace your friendly general practitioner (GP). 

Ultimately, AI-tethered medical devices are a win-win for society. Government loves it because it will save them untold billions in labor/billing costs. Patients love it because they’ll stop getting shuttled everywhere for 3rd and 4th opinions. Healthcare will become substantially more efficient. Unlike the self-driving car or complicated IoT trinket, AI’s use case in the medical arena is unquestionably positive. But there’s much work left to catch up with stringent industry requirements.

Fintech is another huge beneficiary when it comes to AI. Everything from streamlining sales staff, call centers, back office functions and actuaries, AI can help save money. There’s a quiet arms race that the big banks don’t want to broadcast. It’s about who can slash headcount and achieve operational efficiency the fastest. Because whoever wins that race will likely see the biggest investment flows (higher growth).

We saw a glimpse of this recently when Royal Bank of Canada RY (TSE) slashed 450 jobs last June. In isolation, the motion doesn’t seem that unusual. But in truth, sources tell me the aforementioned cuts were only one tranche (of three) the media reported on. All told, about 1500 jobs were slashed during that round of reorganization. The reason? Royal Bank is diving head-first into AI/blockchain development and they’re proactively streamlining operations to make way for their new technological overlords.

If the Canada’s biggest bank is doing it, you can bet the entire “Big Six” complex are too. That was confirmed when Toronto-Dominion Bank TD (TSE) purchased privately-held Layer 6 last month. The aim: to help TD leap to the front of the pack around the world in adopting AI.

As TD Group Head of technological innovation, Michael Rhodes, puts it “The mass amounts of data with increases in computing power really give rise to the ability for machine learning, or artificial intelligence, to really play a much more prominent role”.

In other words, the Big Six are gunning to reduce headcount. With over 400,000 employees countrywide – and perhaps 1/3 of those middle office worker bees in play – it’s going to take lots of investment to get there.

 

Junior AI Stocks We’re Watching Right Now

With our investment thesis firmly in place, we present three AI-based stocks with loads of potential. This isn’t an all-encompassing analysis of each stock, rather, a general topline synopsis on why we like their story. These endorsements also do not suggest you should buy each indiscriminately. Proper risk management should always be followed, along with broader market consideration.

 

First Trust NASDAQ Cybersecurity ETF (CIBR)

We love this niche for a specific reason: cybersecurity spending tends to experience milder cyclical drawdowns than other sectors. Aggregate investment is consistent and even. No serious company risks the integrity of their data just to save a few points in CAPEX.

Characterizing cybersecurity as ‘recession-proof’ is overdoing it, but not by much. While P/E ratios will decline when the broad market corrects, pure-play cybersecurity companies should continue to see stable top line growth.

To exemplify this point, take a look at cybersecurity bellweather Symantec Corporation’s quarterly revenue through the Great Recession. This would have been the envy of many Fortune 500 companies at the time.

In a sense, the sector stands alongside utilities and consumer staples as flights to safety during broad business downturns. Again, skimping out in this mission-critical arena is simply not an option for most companies. That makes this sector ideal for mean regression dip buyers above a selected moving average.

Our investment preference is the First Trust NASDAQ Cybersecurity ETF. Not only does it offer exposure to the biggest, most liquid corporations in the North American market, it also diversifies away from singular innovation risk. With technology changing so rapidly, the hit-and-miss potential for small, undercapitalized small cap tech companies is always elevated. We think the best path is taking a diversified approach only ETFs can offer.

 

Versabank TSE (VB) – Fintech

This company is one of my favorites in the Fintech space. Canada’s first completely digital bank maintains a decided advantage over the Big Six banks when it comes to overhead costs. They maintain very conservative bad loan/bad debt ratios (386.76% vs. 286.76% industry average), meaning they’re in great shape when it comes to impairments should the Canadian economy and housing market fall into recession. With total deposit/total liabilities at 90.01% versus the typical 50% standard, VersaBank has plenty of flexibility to take on risker forms of liability to boost return on capital. These are three important reasons why I think organic growth rates will outperform its peers.

This was confirmed recently during Versabank’s Q4 2017 earnings release. The company saw a 46% Increase in Core Cash Earnings YoY, with net income rising 49%. It’s by far the fastest growing Schedule 1 bank in Canada, albeit owing largely to a lower comps reality.

But the thing that stood out during the earnings release was the commentary of Versabank President & CEO, David Taylor, “Our Bank’s model of using advanced technologies to serve niche markets is demonstrating its tremendous power.” Presumably, this means using smart algorithms and artificial intelligence to source the best loan opportunities while optimizing credit risk.

While the big banks are still predominantly using excel spreadsheets and humans to assess capital deployment, Versabank’s streamlined digital 3.0 model has taken the next step. This stock pick isn’t a true ‘AI’ play per se, it’s using AI effectively to eat its competitors lunch.

On a related front, Versabank is also slated to soon open the world’s first blockchain-based safety deposit box. This should help attract crypto asset investors who use  platforms such as Coinsquare and Coinsbank.

We wouldn’t be at all surprised if a Big Six suitor looks to acquire Versabank at some point. Not necessarily for its modest earnings, but access to new-age banking technology, credit/loan algorithmic models and soon-to-be digital vault. Versabank’s $165M market cap is only about 8 days of Royal Bank of Canada’s net income in Q4 2017. A takeover (even with hefty premium) would barely cause a ripple in their balance sheet.

 

Nanotech Security Company NTS (CVE)

Nanotech designs, manufactures and markets nano-optic products that have brand protection and enhancement applications across a wide range of markets including banknotes, tax stamps, secure government documents, commercial branding, and the pharmaceutical industry. This should be a high-demand industry for the foreseeable future.

I like the fact that Nanotech’s flagship product, KolourOptik security platform, requires patented algorithms, skilled personnel, expensive equipment and class 1 clean rooms to effectively fabricate master shims. The technology isn’t something that can be replicated and repackaged very easily. There’s practically an unlimited amount of use cases in real world applications where counter-proof requirements are needed.

Be forewarned, this is a speculative play. The stock has been languishing of late and expectations of a large contract with the Indian government (which hasn’t materialized) is weighing down sentiment. This research isn’t advanced enough to make a comparative judgement against competitor applications, both is scope and scale.

Still, Nanotech Security Company is worth a look for those with ample speculative capital and further due diligence to further drill into the details.

 

In the coming years, numerous and compelling AI Medtech stocks will be available for public investment. Owing to the youth of the industry, most are currently in the JV stage currently. Midas Letter will keep our readers apprised of the best Medtect investments as they graduate to exchange listings.

 

Disclosure: Neither Midas Letter Publishing Group nor the author own any financial interests in the profiled companies.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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Midas Letter is provided as a source of information only, and is in no way to be construed as investment advice. James West, the author and publisher of the Midas Letter, is not authorized to provide investor advice, and provides this information only to readers who are interested in knowing what he is investing in and how he reaches such decisions.

Investing in emerging public companies involves a high degree of risk and investors in such companies could lose all their money. Always consult a duly accredited investment professional in your jurisdiction prior to making any investment decision.

Midas Letter occasionally accepts fees for advertising and sponsorship from public companies featured on this site. James West and/or Midas Letter may also receive compensation from companies affiliated with companies featured on this site. James West and/or Midas Letter also invests in companies on this site and so readers should view all information on this site as biased.

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