We recently compiled a list of Morgan Stanley's “Most Conviction Stocks: Top 20 Stocks to Buy,” and in this article we'll look at how Spotify Technology SA (NYSE:SPOT) ranks against Morgan Stanley's other high conviction stocks.
As the second half of 2024 settles in, the broader economic environment that will determine the future direction of the stock market is becoming clearer. The increased investor interest in artificial intelligence stocks has pushed macroeconomic conditions into the background for a while, but with the second quarter earnings season almost over, macroeconomics is back in the spotlight. Investors are eager to read Fed Chairman Jerome Powell's thoughts on upcoming interest rate cut decisions and get a sense of which direction the economy will head.
In this regard, investment bank Morgan Stanley has released a plethora of reports to guide investors. One such report was released in July, where it shared the key themes the bank should focus on during the month. Though July is over, the report contains important details that can also provide information on what to expect for the rest of the year. The two biggest takeaways from the report are the possibility of a soft landing for the economy and an expansion in stock performance.
Also see Morgan Stanley's 15 Best AI Stocks in Europe and Morgan Stanley's Best Humanoid Robot Stocks.
Regarding the former, the bank said that in July “inflation fell and several major central banks cut interest rates, strengthening the case for a soft landing.” Forward-looking data suggests that “wage growth in the US and euro area should continue to slow,” which the bank believes will ultimately lead to more muted inflation, lower interest rates and increased chances of a soft landing. In terms of data, the bank's 2025 forecast suggests that year-on-year wage growth could reach 3% in 2025, well above the 2022 peak.
At the time, Indeed's post and the Fed's wage growth figures were around 9.4% and 6.5%, respectively. On a more positive note, the bank adds that the US is leading the EU and the UK, as US wage growth is 3%, less than half of the UK's at around 7%.
On the latter front, MS's belief that stocks could outperform, it said: “There is plenty of room for equity outperformance to outperform, but only if an economic recovery occurs.” This means that the AI boom has seen big tech companies account for most of the market returns this year, and this could spill over to smaller companies, but only if the broader economy recovers. Underpinning this belief is price-to-earnings data for the flagship S&P index, with the bank saying that the 12-month forward price-to-earnings ratio is “21x on a market-cap-weighted basis, but just 16x on an equal-weighted basis.” This suggests there is room for smaller companies to catch up with the larger players, but their performance will only improve if consumer and business spending picks up during an economic recovery.
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Given this possibility, the bank laments that it “turned to neutral too early.” It also cites future earnings data to support its valuation polarization hypothesis. For the Magnificent Seven stocks, the 12-month future earnings as of December 2023 are a whopping 120, compared with about 106 for the remaining 493 companies in the S&P index. But before getting too optimistic, MS also warns against investing in small caps. It says that small caps “need faster economic growth with low interest rates, which is unlikely in the current inflationary environment.” When small cap returns are plotted against bond yields to show the relationship with interest rates, the relative return of small caps to large caps was 100% when bond yields were 1%. But when yields spiked to about 5.6%, these returns fell to about 82%.
MS's August report continues the theme from July. Given the bearish backdrop for small caps, the report shifts focus from inflation to the labor market and covers real estate. The bank said that suppressing wage growth could allow the Fed to shift focus from inflation to “potential cracks in the labor market,” but warned that “the thumb rule, an indicator of a recession, is approaching the recession threshold based on the rising national unemployment rate.” According to the bank's data, the three-month national unemployment average is 0.5% above its 12-month low, which is alarming to say the least. It remains bearish on small caps, adding that “recent inflation data and the associated decline in interest rates have helped small caps rise, but softening economic data could curb continued small cap outperformance.”
However, there are positives in the August report. The bank notes that commercial real estate, one of the sectors hit hardest by rising interest rates and changing trends to remote work, now offers a “new opportunity set.” The analysts outline that commercial real estate valuations are “becoming more attractive in the face of rising interest rates and increasing supply,” adding that “we expect transaction volume to increase this year as debt maturities approach, reinforcing these low entry points.” Counterintuitively, this optimism is based on depressed valuations, as it uses commercial real estate cap rates. According to MS data, this rate was 9% in March 2024, giving it a lead of about 2 percentage points over retail real estate and 3 percentage points over residential real estate. The bank is also very impressed with hedge fund performance in 2024, commenting that “the fund delivered attractive risk-adjusted performance in the first half of 2024 and its positioning demonstrates confidence in skill-based return opportunities.”
Our Methodology
To create our top MS stock list, we used the most recent top 20 promising stock ideas and ranked them by the average percentage price upside relative to the bank's own price target.
We also mentioned the number of hedge fund investors in these stocks. Why are we interested in stocks where hedge funds are concentrated? The reason is simple: our research shows that by mimicking the top stock picks of the best hedge funds, you can outperform the market. Our quarterly newsletter strategy selects 14 small and large stocks each quarter and has returned 275% since May 2014, beating the benchmark by 150 percentage points (more details here).
A person wearing headphones listening to an audio streaming service.
Spotify Technology SA (NYSE:SPOT)
Stock price increase: 19%
Number of hedge fund investors in Q2 2024: 88
Spotify Technology SA (NYSE:SPOT) is a popular audio streaming company headquartered in Luxembourg, but with operations concentrated in the United States. The company has been able to leverage the utility and popularity of the Internet to provide audio content to its users, giving it a first-mover advantage in an industry favored by the working population. Spotify Technology SA (NYSE:SPOT) is expected to add 113 million net users and 31 million premium users, respectively, in 2023, giving it a 32% market share in the global music streaming market. Spotify Technology SA (NYSE:SPOT)'s dominance is also reflected in its revenue, which is growing from €9.6 billion to €13.2 billion between 2021 and 2023. According to data, the company has 600 million monthly active users, and the main drivers of the hypothesis are further user growth, user retention, paid user growth, and cost control for Spotify Technology SA (NYSE:SPOT) to be profitable.
Artisan Partners mentioned Spotify Technology SA (NYSE:SPOT) in its investor letter for Q2 2024. Here is what the fund said:
“Spotify is the world's leading audio streaming franchise with 600 million monthly active users. We believe its position in the supply chain is strong given long-term trends around music fragmentation and in-house product and pricing efforts. Shares rose after the company reported strong results, including 21% revenue growth. Importantly, the company reported gross margins expanded to 27.6%, and we believe they can expand further with potential price increases, potential improved terms with labels, and further cost controls.”
Overall, SPOT ranks 13th on Morgan Stanley's list of highest conviction stocks. While we acknowledge SPOT's potential as an investment, we believe some AI stocks have a better chance of delivering higher returns in a shorter time frame. If you're looking for AI stocks that are more promising than SPOT but still trade for less than 5x its earnings, check out our report on the cheapest AI stocks.
Read next: The $30 Trillion Opportunity: The 15 Best Humanoid Robot Stocks to Buy According to Morgan Stanley and NVIDIA Has “Become a Wasteland” According to Jim Cramer.
Disclosures: None. This article was originally published on Insider Monkey.
