We recently compiled a list of the Morgan Stanley’s Best Stocks For Economic Recovery: Top 9 Cyclical Stocks. In this article, we are going to take a look at where Spotify Technology S.A. (NYSE:SPOT) stands against the other cyclical stocks.
As 2024 approaches its end, the stock market has been through it all. The driving theme of the year has been artificial intelligence as investors and media have ardently poured over AI companies’ every word during all earnings seasons. Alongside AI, the Federal Reserve has been focused on tailoring its interest rate policy to match the labor market’s performance and inflation. Finally, November ends with the result of the 2024 US Presidential Election confirming President-elect Donald Trump’s victory.
These three primary stock market drivers have short and long-term implications for equities. AI companies have to ensure that their margins are robust and that the technologies they have invested billions of dollars into can generate profits. The Fed’s interest rate decisions will determine liquidity for institutional investors, venture capitalists, and the broader corporate sector. Finally, the incoming administration’s policies towards sectors such as energy, banking, and clean energy might shape the macroeconomic environment either to their benefit or encumbrance.
Therefore, it’s worth seeing what the professionals are saying within this dynamically shifting stock market environment. On this front, investment bank Morgan Stanley has plenty of research floating around. Starting from the bank’s head of applied equity team Andrew Slimmon, he believes that the outcome of a Presidential election has rarely impacted the pre-election trend of the flagship S&P stock index. According to Slimmon, if the market has been in an uptrend heading into the election, then it “has been higher 3 and 6 months later 85% of the time, regardless of the election outcome.” He adds that the market has been in an uptrend year as well, and looking at history, November and December are typically the two strongest months for the market.
The MS analyst believes that while this two-month period is the strongest in history, historically, it also “follows the two worst months of the year.” As September and October have not followed this trend, one key historical factor does not match. However, Slimmon is optimistic, going on to outline that “November-December will repeat its historic strong performance once we get through the noise surrounding the election.” Four key reasons are behind this optimism. As per Slimmon, November sees the highest number of corporate buybacks and the most retail funds flow into the market, there will be post-election clarity for firms, and the Fed’s interest rate cuts, no matter how small, are always great for the market. The analyst also cycles back to his opinion that pre-election trends continue to persist post-election, and he shares that communications services, utilities, and financials are some sectors that have performed well before the election.
Jim Caron, MS’ CIO of the Portfolio Solutions Group, shares his take on the remaining unknowns for the stock market now that the election is over. Focusing on the Federal Reserve’s path ahead, he shares that the process of managing interest rates is now “an exercise in risk management” for the central bank. This is because the Fed has to carefully balance between ensuring that interest rates are in neutral territory as implied by the R* or the rate that ensures the economy is in equilibrium. Right now, Caron believes that the rates are in restrictive territory, and the primary risk that the Fed is managing is the condition of the labor market which “would be worsened if policy rates were restrictive when it happened.” This leads Caron to conclude that the Fed might cut rates to range between 4% and 3.7%, and on a more optimistic note, this “may be the case even if the decline in inflation seems to be stalling perhaps temporarily because if they don’t cut rates now, they may not be able to if there are some unfriendly inflation prints ahead.”
What does this careful balance between cutting rates to ensure the labor market remains robust while simultaneously keeping an eye on inflation mean for investors? Well, according to the MS analyst, in the worst-case scenario that the central bank “switches their policy from cutting to hiking,” the 10-year bond yields should range between 3.9% and 4.6%. Not only does this mean that “owning bonds can also be a good hedge against equities,” believes Caron, but he adds that equities ” should still find support and value from a stable and lower bond yield environment.” He concludes by outlining that MS’ portfolio realignment includes moving “to increase equity exposure at duration to hedge and moving into levered credit, December carries with its special significance beyond the normal year-end dynamics, it will set the stage for how Fed policy may move markets.”
Finally, before we head to our list of Morgan Stanley’s top cyclical stock picks, the bank’s key themes for November are also worth noting. On the topic of equities, the bank shares in its November 2024 Beat report that “Financials offer an attractive risk/reward across both our base-case, soft-landing view and a potential risk scenario where inflation concerns return and lift rates higher.” Naturally, any market report without mentioning artificial intelligence would be incomplete, and for MS, utility stocks are among the key AI beneficiaries. It outlines that “utility companies are in the early stages of what will be a multi-year capital expenditure cycle designed to increase their power generation capacity and service new demand.”
Just like Goldman Sachs, MS also believes that there is great potential in the equal-weighted flagship S&P index. Its data shows that when compared to the index’s long-term median 12-month forward consensus EPS of roughly 2%, the EPS of the market cap weighted index is 5.9%. This shows that the cap-weighted index is fully valued, but, for the equal-weight index, the consensus forward estimates are 1.5% which hints at undervaluation. The differential leads MS to conclude that “S&P equal-weighted EPS offer a cleaner comparison and show scope for cyclical EPS upside.”
On the topics of financial stocks and the benefits stemming from artificial intelligence on utilities, MS shares that financial stocks “offer an attractive risk/reward profile.” This optimism is driven by the sector’s exposure to interest rates. In its data, the bank outlines that when compared to materials, industrial, and energy stocks, as well as the spread between 10-year and 2-year bonds, financial stocks offer as much as a 15-point performance gain over a base of 100 points. It adds that financial stocks also lead cyclical stocks when Citi’s US Economy Surprise Index starts to edge higher. As for utilities, the bank shares that positive “forecasts for the data center buildout have helped catalyze outperformance for utilities relative to other defensive sectors.”
For some financial stocks, you can check out 10 Best Local Bank Stocks To Invest In Now and 10 Best Diversified Bank Stocks to Buy Now.
Our Methodology
To make our list of Morgan Stanley’s top cyclical stocks, we ranked the bank’s recent list of favored cyclical stocks by the number of hedge funds that had bought their shares in Q3 2024.
Why are we interested in 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).
A person wearing headphones listening to an audio streaming service.
Spotify Technology S.A. (NYSE:SPOT)
Number of Hedge Fund Holders In Q3 2024: 98
Spotify Technology S.A. (NYSE:SPOT) is the largest audio streaming company in the world. The firm is synonymous with the concept of podcasts and it also commands a 32% market share of the global music streaming market. Spotify Technology S.A. (NYSE:SPOT) enjoys a wide moat in the industry courtesy of its 600 million users. The sizable user base has come on the back of rapid growth as the firm managed to add 113 million net and 31 million paid users in 2023. Spotify Technology S.A. (NYSE:SPOT)’s narrative depends on several factors such as its ability to add paying premium users and growing its ad-supported users to monetize its massive user base. Additionally, since the firm relies primarily on a software platform to generate revenue, margins are another key part of Spotify Technology S.A. (NYSE:SPOT)’s puzzle. Its ability to monetize its user base plays a key role in bolstering margins since it allows the firm to eke out additional revenue without adding to costs. Delivering on these fronts can create tailwinds for Spotify Technology S.A. (NYSE:SPOT)’s shares and vice versa.
Spotify Technology S.A. (NYSE:SPOT)’s management commented on its margins during the Q3 2024 earnings call. Here is what they said:
“We also anticipate gross margin of 31.8% and operating income of EUR481 million, pointing to our first full year of positive operating income of EUR1.4 billion. With respect to subscriber net additions, the very low levels of churn that we expect in the six markets where we’ve recently announced price increases is also incorporated into our quarter four outlook. This is consistent with what we had seen historically. We have also incorporated our ongoing actions to drive better subscriber monetization. Although new pricing will contribute towards ARPU growth in quarter four overall, we expect the lapping of 2023 year’s price increases that we had in 63 markets that they will lead to an approximately 400 basis point moderation of a year-on-year ARPU growth on a constant currency basis in our revenue outlook.
In terms of our recent gross margin improvement, as Daniel mentioned, we are very pleased with the strides we made this year. The significant rate of improvement in our gross margin in 2024, which exceeded even our own plans has been exceptional and should be viewed as such. Looking ahead, we see substantial runway to grow margins and income over the long run, which will be driven by continuing focus on improving our product and business via targeted investments, disciplined management and improving monetization.”
Overall SPOT ranks 4th on Morgan Stanley’s list of cyclical stocks that are best for economic recovery. While we acknowledge the potential of SPOT as an investment, our conviction lies in the belief that 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 SPOT but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
READ NEXT: 8 Best Wide Moat Stocks to Buy Now and 30 Most Important AI Stocks According to BlackRock.
Disclosure: None. This article is originally published at Insider Monkey.