We recently made a list of Morgan Stanley’s Best Overweight & Quality Stocks: Top 25 Stocks. In this piece, we will look at where Eastman Chemical Company (NYSE:EMN) ranks on the list of the top overweight and quality stocks.
The close of September has cemented the paradigm shift on Wall Street. With the Federal Reserve’s first interest rate cut being all that investors could hope for as it reduced rates by 50 basis points, since the cut, the flagship S&P stock index and the broader NASDAQ stock index are up by 2% and 3%, respectively. The rate cut has also now moved Wall Street’s focus to the next big catalyst for the stock market, i.e, the third quarter earnings season.
For a market that has touched new highs this year due to artificial intelligence, the second quarter earnings season was nothing short of fireworks. It saw the AI narrative wobble temporarily after mixed results from the world’s leading AI GPU designer and the semiconductor industry reckoned with the fate of the semiconductor manufacturing stock that ranked 5th on the list of Jim Cramer’s Top 12 Must-Watch Stocks.
Starting with the chip maker, its second quarter earnings were nothing short of a bloodbath. They saw the firm’s non GAAP net income drop by a whopping 85% annually and turn a year ago GAAP net income into a non GAAP loss of $1.6 billion. At the same time, its gross margins dropped by 0.4 percentage points, and in the worst example of the cherry on top, the firm also announced that it will be suspending dividends starting from the fourth quarter. As a result, its shares tanked by 30% after the earnings, and since then, we’ve seen multiple reports claim that other companies are interested in acquiring it.
As for the GPU designer, its second quarter revenue jumped by 122% – a no small feat considering that the year ago quarter’s revenue was $13.5 billion. However, even as the Q2 revenue of $30 billion beat analyst estimates of $28.7 billion which was fueled by its AI data center division’s revenue jumping by 154% annually, the shares fell by 6% in extended trading. At the heart of the fall was a tepid third quarter guidance of $32.5 billion (analyst estimates were $31.77 billion), a gross margin miss by 0.1 percentage point, a Q3 margin guidance miss by 0.5 percentage points, and the delay of its Blackwell GPU to the fourth quarter. For investors already worried about the ability of AI to generate a profit, the margin miss in particular wasn’t comforting. Consequently, since the earnings report, the firm’s shares are down by 1%.
However, investment bank Morgan Stanley sent the GPU designer’s shares soaring by 6.8% in September in a bullish note that shared that the firm could earn $10 billion in its fourth quarter alone from the latest Blackwell chips. This upgrade came on the back of MS remaining consistent in its analysis of the stock market this year. The key themes that it has identified are the labor market, commercial real estate, and the split in the stock market between large and small cap stocks.
In July, the bank shared that there was “ample room for equities performance to broaden, but this requires a cyclical recovery.” In simpler terms, it means that MS believed that for small cap equities to catch up to large caps in performance, the economy has to perform well. If you’re wondering how wide this gap is, data shows that for small and medium cap and large cap stocks which are in the top 20% in terms of free cash flow margins, the small and mid caps have a forward price to earnings ratio of 0.74x relative to large caps as of April 2024, which is quite low when compared to the April 2009 peak of 1.62x. MS reiterated this belief in its August report, which shared that small cap outperformance “requires economic growth acceleration with lower interest rates. While recent inflation data and the resulting decline in rates was a lift to small cap, softer economic data may constrain its continued outperformance.”
However, MS’ September report took somewhat of a different tune. It focused on the clean energy and infrastructure investments in the US to share that these could help some segments of the American stock market that are typically dependent on growth in economic activity. Government spending through the Inflation Reduction Act (IRA), the Bipartisan Infrastructure Law (BIL), and the CHIPS and Science Act have led to roughly $500 billion in commitments by the private sector to invest in a diverse set of areas ranging from roads, to clean energy manufacturing and heavy industry.
As per the bank, “Government policies such as the CHIPS Act, the Inflation Reduction Act (IRA), and the Infrastructure Act are sponsoring growth in many areas of U.S. manufacturing. These trends could offer through-the-cycle structural support to areas of the economy that are traditionally very cyclical.” On the data front, MS reveals that while in 2022, US manufacturing capacity as a percentage of 2017 output sat at ~126%, this has jumped to nearly 129% as of 2024.
Shifting gears, the third quarter earnings season will soon start to shape how investors view the market. Data from LSEG shows that the flagship S&P index is expected to deliver 5.4% annual earnings growth during Q3. FactSet is more cautious, as it shares that the index should grow earnings by 4.6% annually to mark its sixth straight quarter of growth. MS is of the view that the economy has to continue to deliver on the data front if the stock market is to perform well.
In a recent podcast, the bank’s chief investment officer and chief strategist, Mike Wilson, shared that “the unemployment rate will need to decline and the payrolls above 140,000 with no negative revisions to prior months. Meanwhile, I am also watching several other variables closely to determine the trajectory of growth. Earnings revision breadth, the best proxy for company guidance, continues to trend sideways for the overall S&P 500 and negatively for the Russell 2000 small cap index. Due to seasonal patterns, this variable is likely to face negative headwinds over the next month.”
Our Methodology
To make our list of Morgan Stanley’s best Overweight and quality stocks, we ranked the bank’s recent list of 66 stocks with Overweight ratings, a higher than median quality score, and one month upward EPS revisions by their percentage one month average analyst revisions. The average EPS data was sourced from Yahoo Finance as of September 26th 2024, and the top 25 stocks with non zero percent revisions were selected.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
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Eastman Chemical Company (NYSE:EMN)
Number of Hedge Fund Holders In Q2 2024: 28
Average Analyst EPS % Revision: 0.5%
Eastman Chemical Company (NYSE:EMN) is a diversified chemical company that caters to the needs of construction, aviation, pharmaceutical, aviation, agriculture, and other industries. The industrial focus of its business means that it is exposed to economic headwinds that slow down industrial production. Consequently, Eastman Chemical Company (NYSE:EMN)’s shares are up by a modest 25% year to date, with 11 percentage points of these gains having come in September. In fact, September has been a great month for Eastman Chemical Company (NYSE:EMN)’s shares with the stock having gained 9%. The chemical company benefits from a low rate environment that increases industrial output, and Eastman Chemical Company (NYSE:EMN)’s hypothesis is also dependent on its ability to spur polyester recycling. The firm has opened a new plant for this in Tennessee, and another facility in Texas is expected to help big ticket firms like Pepsi meet their recycled materials needs. Additionally, since a slow industrial economy has led to inventory buildups over the past few quarters, Eastman Chemical Company (NYSE:EMN) is likely to benefit from higher de stocking and inventory replenishment moving forward.
Eastman Chemical Company (NYSE:EMN)’s management commented on industry inventory levels during the Q2 2024 earnings call. Here is what they said:
“So when you look at sort of where we are with the Tritan market, a lot of that goes in consumer durables as everyone I think in the industry has called out that market’s been weak. It continues to be weak. But we did see a significant amount of return in volume with the end of destocking. So a huge amount of the hit that we took in 2023 was associated with destocking. That volume has come back and the very high margins that go with it are certainly very helpful this year and will be going forward. We also continue to have a lot of wins just on the traditional value proposition of Tritan. So when you look at the compelling attributes of its heat resistance, its chemical resistance, its clarity, it being a safe product that’s BPA free.
We’ve always had a lot of volume wins in applications that’s driven tremendous growth in this product area for over a decade. That engine’s back in gear this year. We’re winning on those value propositions a variety of places on top of end of destocking that’s giving us good momentum. And then on top of that, we’re now layering on recycled content. And for a lot of brands, that’s really important. We have a lot of customers that have been with us for a long time that are using this recycled content claim as a way to enhance their product offering or drive new volume growth like P&G, NowGene, [indiscernible], LVMH, and L’Oreal, Estee Lauder, etc. You’ve seen the icon chart of all the customers we’ve had who are using in one form or another. And then we’ve — what’s really exciting is also opening up new markets for us to serve that wouldn’t have originally been available for our value proposition.”
Overall EMN ranks 13th when we look at Morgan Stanley’s top overweight stocks. While we acknowledge the potential of EMN as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than EMN but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article was originally published on Insider Monkey. All investment decisions should be made after consulting a qualified professional.
