The market rallied massively yesterday in anticipation of strong earnings from tech heavyweights Microsoft (MSFT) and Alphabet (GOOG, GOOGL). In fact, the Top 10 portfolio in our flagship investment research service Innovation Investor soared almost 10% yesterday!
But both Microsoft and Alphabet dropped the ball.
Both tech stocks tanked after-hours – and dragged the whole market down with them.
Thinking about buying the dip? Fair. After all, both Microsoft and Alphabet are fabulous companies. And it’s typically a great investment strategy to buy the dip in fabulous companies.
But only one of those stocks is a strong buy on this dip. The other? Well, not so much.
Here’s a deeper look.
Falling Tech Stocks: Think Twice About MSFT
Ostensibly, Microsoft’s quarterly numbers were quite good.
Revenues and earnings beat. Cloud growth accelerated in the quarter. Gross margins held stable at 69%. Constant currency revenue growth was stable at 16%.
But the guidance spooked investors, with management guiding for cloud growth rates to decelerate next quarter and FX headwinds to intensify. The result? Revenue growth will likely slow next quarter, while margins will likely compress.
Of course, these issues are temporary. Microsoft’s cloud business is second to none. The cloud industry has very large long-term growth potential, and the dollar can’t remain strong forever. Eventually, Microsoft will return to its normal 15%-plus constant-currency revenue growth cadence with healthy profit-margin expansion and 20%-plus profit growth.
But not now.
Right now, the dollar is still very strong. Enterprise spending is slowing, and advertisers are pulling back their budgets. And right now, Microsoft’s growth trajectory will not be 15%-plus revenue growth with 20%-plus profit growth.
Without that growth profile, Microsoft stock will struggle here and now.
That’s because with MSFT, you have an asset trading at 24.5X forward earnings for that sub-20% profit growth profile. That’s too rich.
Therefore, we wouldn’t be in a hurry to buy the stock on this dip. The valuation is still quite rich. Let it compress a bit. Let the growth narrative regain some momentum. Then, go ahead and buy the dip.
But not here.
Time to Get Aggressive With Alphabet Stock
At first glance, Alphabet’s numbers were a lot uglier than Microsoft’s numbers. Alphabet missed quarterly revenue and earnings estimates. And one of its core businesses – YouTube advertising – actually experienced negative revenue growth last quarter.
Revenue growth slowed to just 11% in constant currency, its lowest rate since at least 2014. Profit margins compressed about 750 basis points year-over-year and 310 basis points quarter-over-quarter. Earnings growth screeched to a halt.
But when you dig into the numbers, you’ll find that the weakness was all due to two things: an ad recession and FX headwinds. As mentioned earlier, neither will last for too long. Ad spending will come back, likely within the next 12 months. And the strong dollar will moderate in the near future.
Much like Microsoft, Alphabet will soon return to its normal growth cadence of 10%-plus revenue growth with healthy margin expansion. Unlike Microsoft, though, Alphabet stock is fully priced for its slowdown.
Microsoft stock is trading at 24.5X next year’s EPS estimates. Alphabet stock is trading at just 17.5X next year’s EPS estimate. Both companies are expected to grow EPS at a mid-teens compounded annual growth rate over the next five years.
In other words, Alphabet and Microsoft have nearly identical five-year growth profiles. Yet, Alphabet stock is trading at a ~30% lower P/E multiple.
That’s why we say pass on Microsoft stock, and buy GOOGL on the dip. Below $100, Alphabet stock is one of the most compellingly undervalued tech stocks in the market today.
The Final Word on Titan Tech Stocks
In this stock market, valuation matters.
The days of “growing at all costs” are over. The days of “profits are king” are here. These days, the stocks that will perform best are the ones trading at a discounted valuation – the cheap stocks, if you will.
At 17.5X forward earnings for mid-teens EPS growth, Alphabet stock is a “cheap stock.” And at 24.5X forward earnings for the same growth profile, Microsoft stock is not.
So, in this market, don’t buy the dip in Microsoft stock. Let it fall until it becomes a cheap stock. In the meantime, buy the dip in Alphabet stock. Its cheapness should allow it to succeed where other stocks will fail.
But Alphabet stock isn’t the only stock that will succeed over the next few months due to its “cheapness.”
The market selloff of 2022 has left dozens of stocks significantly undervalued here in October. We’ve put together a portfolio of the best-of-the-best of those ultra-cheap stocks. And we fully expect that portfolio to soar in 2023!
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.