We recently compiled a list of the Morgan Stanley’s Highest Conviction Stocks: Top 20 Stocks To Buy. In this article, we are going to take a look at where Schlumberger Limited (NYSE:SLB) stands against Morgan Stanley’s other high conviction stocks.
With the second half of 2024 having settled in, the broader economic environment that will determine the future course of the stock market is becoming clearer. While the surge in investor interest surrounding artificial intelligence stocks placed the macroeconomic picture in the background for a while, now, as the second quarter earnings season is nearly over, macroeconomics is coming back into play. Investors are eager to read the mind of Fed chairman Jerome Powell for future interest rate cut decisions and the crystal ball to see what way the economy is heading.
On this front, investment bank Morgan Stanley has been churning out quite a lot of reports to guide investors. One such report came out in July and shared the bank’s key themes to focus on during the month. While July is over, this report contains key details that can provide information about what to expect for the rest of the year too. Two of the biggest takeaways from this report cover an economic soft landing and the potential for equities performance to widen.
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On the former front, the bank shared that July “bolstered the case for a soft landing as inflation has declined and a few major central banks cut rates.” It believes that forward looking data suggests that “wage growth should continue to slow in the U.S. and Eurozone” which will eventually contribute to cooling inflation and eventually lower rates to increase the chances of a soft landing. In terms of data, the bank’s estimates for 2025 suggest that year over year wage growth could sit at 3% in 2025 for a marked growth over the 2022 peak.
Back then, wage growth percentages as indicated by Indeed postings and the Fed had stood at ~9.4% and ~6.5%, respectively. As an additional positive note, the bank also adds that the US is leading the EU and the UK because of its wage growth of 3% which is less than half of the UK’s roughly 7%.
On the latter front, i.e., MS’ belief that equities performance can widen, it shares that there “is ample room for equities performance to broaden, but this requires a cyclical recovery.” What this means is that big tech has accounted for most of the market’s returns this year due to the AI hype, and this can spread out to smaller firms but only if the broader economy recovers. Underlying this belief is data for the flagship S&P index’s price to earnings ratio, as the bank shares that the 12 month forward P/E “runs at 21x on a cap-weighted basis but only 16x equal- weighted.” This suggests that the smaller companies have room to catch up with the larger companies, but their performance will only improve if consumer and business spending flourishes during a cyclical uptrend.
This potential has led the bank to lament that “we turned neutral too soon” as it also cites forward earnings data to support the hypothesis of the bifurcation in valuation. For the Magnificent Seven stocks, the 12 month forward earnings rebased to 100 as of December 2023 sit at a whopping 120 while the estimate for the remaining 493 firms on the S&P index is ~106. However, before you get too optimistic, MS also cautions against investing in small cap stocks. It shares that small cap “requires economic growth acceleration with lower interest rates, which seems unlikely in the current inflation environment.” Plotting the returns of small caps with bond yields to signify a relationship with interest rates, its data shows that when bond yields were at 1%, small cap relative returns to large caps were 100%. But when the yields soared to ~5.6%, these returns dropped to ~82%.
MS’ August report builds on the July themes. It builds on the bearishness surrounding small caps, shifts the focus on the labor market over inflation, and brings real estate into the mix. Reducing wage growth allows the Fed to shift its focus from inflation “to potential cracks in the labor market,” says the bank, but it cautions that recession “indicators such as the Sahm Rule are creeping toward a recessionary threshold based on the rising national unemployment rate.” Its data shows that the 3 month national unemployment average is 0.5% over the previous 12 month low, which rings a warning bell, to say the least. Still bearish on small caps, it adds that while “recent inflation data and the resulting decline in rates was a lift to small cap, softer economic data may constrain its continued outperformance.”
There is some positivity in the August report, though. The bank shares that commercial real estate, which has been one of the hardest hit sectors from rising rates and shifting trends to remote working, now presents an “emerging opportunity set.” The analysts outline that commercial real estate valuations “valuations have become more attractive in the face of higher interest rates and elevated supply,” adding that they “expect volumes to pick up this year due to upcoming debt maturities, reinforcing these lower entry points.” Counterintuitively, this optimism is based on depressed valuations as it uses the commercial real estate cap rate. As per MS’ data, this rate sat at 9% in March 2024, for nearly a two percentage point lead over retail real estate and a wider three point lead over residential real estate. The bank is also quite impressed with hedge fund performance in 2024 as it commented that the funds “delivered attractive risk-adjusted performance in the first half of 2024 and their positioning suggests confidence in the opportunities for skill-based returns.”
Our Methodology
To make our list of MS’ top stocks, we used its latest 20 top conviction stock ideas and ranked them by the average percentage share price upside to the bank’s own share price targets.
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).
An aerial view of a well site, depicting the scale of oil and gas operations.
Schlumberger Limited (NYSE:SLB)
Share Price Upside: 45%
Number of Hedge Fund Investors In Q2 2024: 67
Schlumberger Limited (NYSE:SLB) is the biggest oilfield services provider in the world. This allows it to generate substantial revenues, and the industrial nature of its business means that future cash flows and revenues are visible through its order pipeline and backlog. Additionally, Schlumberger Limited (NYSE:SLB)’s competitive position is bolstered by the fact that it counts some of the biggest oil companies in the world such as Petrobras and Saudi Aramco as its customers. Schlumberger Limited (NYSE:SLB) however remains vulnerable to dropping production activities, especially like the one the oil industry has risked recently due to weak Chinese economic growth depressing the oil market. However, the firm’s $3.9 billion in cash and equivalents and trailing twelve month free cash flow of $4.3 billion provide it with ample room to keep investors happy during downturns by conducting share buybacks and dividend payouts.
Artisan Partners mentioned Schlumberger Limited (NYSE:SLB) in its Q4 2023 investor letter. Here is what the firm said:
“We have stringent criteria for business quality, which is particularly important in commodities sectors as these businesses do not control the underlying commodity prices, which can be volatile. We expect Schlumberger to continue to successfully navigate market volatility and deliver on its free cash flow and profit margin growth objectives from combination of activity growth and pricing gains. The stock has been among our top contributors since we initiated our position in December 2020.”
Overall SLB ranks 2nd on our list of Morgan Stanley’s highest conviction stocks. While we acknowledge the potential of SLB 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 SLB 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 is originally published at Insider Monkey.
