We recently created a list of Morgan Stanley’s best overweight and quality stocks: Top 25 Stocks. In this piece, we will look at where Unity Software Inc. (NYSE:U) is on the list of the largest overweight and quality stocks.
The end of September has reinforced the paradigm shift on Wall Street. Since the Federal Reserve’s first rate cut was all investors could hope for as rates were cut by 50 basis points, the main S&P stock index and the broader NASDAQ stock index have risen 2% and 3%, respectively, since the cut. The rate cut has now also shifted Wall Street’s focus to the next big catalyst for the stock market, which is third-quarter earnings season.
For a market that has reached new highs this year thanks to artificial intelligence, the second quarter earnings season has been nothing short of fireworks. It saw the AI story temporarily falter after mixed results from the world’s leading AI GPU designer and the semiconductor industry factored in the fate of the semiconductor manufacturing stocks that ranked fifth on Jim Cramer’s list of Top 12 Must-Watch Stocks .
Starting with the chipmaker, its second-quarter earnings results were nothing short of a bloodbath. They saw the company’s non-GAAP net income decline by as much as 85% annually, turning GAAP net income into a $1.6 billion non-GAAP loss a year ago. At the same time, gross margins fell by 0.4 percentage points, and in the worst example of icing on the cake, the company also announced that it will suspend dividends starting in the fourth quarter. As a result, shares plummeted 30% after earnings, and since then we’ve seen multiple reports claiming that other companies are interested in acquiring it.
As for the GPU designer, Q2 revenue rose 122% – no small feat considering last year’s quarter revenue was $13.5 billion. But even as second-quarter revenue of $30 billion beat analyst expectations of $28.7 billion, fueled by AI data center division revenue rising 154% annually, shares fell in extended trading with 6%. At the heart of the decline was a tepid third-quarter guidance of $32.5 billion (analyst estimates were $31.77 billion), a gross margin miss of 0.1 percentage point, a third-quarter margin forecast of 0.5 percentage point , and the Blackwell GPU delay to Q4. For investors who were already concerned about AI’s ability to generate profits, the missed margin in particular was not reassuring. As a result, the company’s shares are down 1% since the earnings report.
However, investment bank Morgan Stanley sent the GPU designer’s shares up 6.8% in September, in a bullish tone that shared that the company could earn $10 billion in the fourth quarter alone from the latest Blackwell chips. This upgrade came as MS remained consistent in its analysis of the stock market this year. The key themes it identified are the labor market, commercial real estate and the stock market divide between large and small cap stocks.
In July, the bank said there was “plenty of room to broaden equity performance, but this will require a cyclical recovery.” In simpler terms, this means that Member States believe that the economy must perform well if small company shares are to catch up with the performance of large companies. If you’re wondering how big this gap is, data shows that for small-cap, mid-cap, and large-cap stocks, which are in the top 20% of free cash flow margins, the small- and mid-cap stocks have a price-to-earnings ratio. of 0.74x versus large caps as of April 2024, which is quite low compared to the peak of 1.62x in April 2009. MS reiterated this belief in its August report, which stated that small cap outperformance would “accelerate economic growth requires lower interest rates. While recent inflation data and the resulting drop in interest rates have been a boost for small cap, softer economic data may limit its continued outperformance.”
However, MS’s September report had a slightly different tone. It focused on U.S. clean energy and infrastructure investments to indicate they could help some segments of the U.S. stock market, which typically rely on growth in economic activity. Government spending through the Inflation Reduction Act (IRA), the Bipartisan Infrastructure Law (BIL), and the CHIPS and Science Act has led to roughly $500 billion in private sector commitments to invest in a wide range of areas ranging from roads to clean energy production and heavy industry.
According to 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 can provide structural support throughout the cycle to parts of the economy that are traditionally highly cyclical.” On the data front, MS shows that while in 2022 US production capacity as a percentage of 2017 production was at ~126%, it has increased to almost 129% from 2024 onwards.
Shifting gears, the third-quarter earnings season will soon determine how investors view the market. Data from LSEG shows that the main S&P index is expected to post annual earnings growth of 5.4% in the third quarter. FactSet is more cautious, sharing that the index should grow earnings 4.6% annually, which would mark the sixth consecutive quarter of growth. MS believes that the data economy must continue to deliver if the stock market is to perform well.
In a recent podcast, Mike Wilson, the bank’s chief investment officer and chief strategist, shared that “the unemployment rate should fall and payrolls should exceed 140,000 without negative revisions from previous months. Meanwhile, I’m also keeping a close eye on several other variables to determine the growth trajectory. The range of earnings revisions, the best measure of business advice, continues to trend sideways for the overall S&P 500 and negative for the Russell 2000 small cap index. Due to seasonal patterns, this variable is likely to face negative headwinds in the coming month.”
Our Methodology
To create our list of Morgan Stanley’s top Overweight and Quality stocks, we ranked the bank’s recent list of 66 stocks with an Overweight rating, a Quality Score above the median, and one-month upward EPS revisions based on their percentage of average analyst revisions over a month. The average EPS data was sourced from Yahoo Finance as of September 26, 2024, and the top 25 stocks with revisions less than zero percent were selected.
We also reported the number of hedge fund investors for these stocks. Why are we interested in the stocks that hedge funds invest in? The reason is simple: our research shows that we can outperform the market by imitating the best stock picks from the best hedge funds. Our quarterly newsletter strategy selects 14 small- and large-cap stocks each quarter and has returned 275% since May 2014, beating the benchmark by 150 percentage points. (see more details here).
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Unity Software Inc. (NYSE:U)
Number of hedge fund holders in the second quarter of 2024: 34
Average earnings per share percentage revision for analysts: -2.7%
Unity Software Inc. (NYSE:U) is a software company that provides developers with tools to create video games. It is a sizable company with operations in Europe, the US and China, along with a platform that supports consoles, PCs, headsets and handhelds. Considering that it focuses exclusively on video games, the hypothesis of Unity Software Inc. (NYSE:U) relies primarily on consumer spending and a steady stream of titles to attract users to its titles. Moreover, you are also a software company. makes it possible to take advantage of high-margin activities. The shares of Unity Software Inc. (NYSE:U) are down 42% year to date, while peers like EA have gained 5.9%. This means that the gaming company’s problems are of its own making, and mainly stem from a pricing error last year where the company tried to charge fees based on the number of users who installed a game. The decision was not well received and Unity Software Inc. (NYSE:U) followed this up by reducing its workforce. During the second quarter, Unity Software Inc.’s revenue declined. (NYSE:U) rose 16% and lowered its guidance for the year to a midpoint of $1.685 billion. However, Morgan Stanley is optimistic as it believes the share price decline and lowering of expectations have now de-risked the stock. The bank also believes that Unity Software Inc. (NYSE:U) has a 70% market share for mobile game engines, giving it a stable market to navigate.
Carillon Tower Advisors listed Unity Software Inc. (NYSE:U) in its Q2 2024 investor letter. Here’s what the fund said:
“Unity Software, a leading provider of mobile game development and monetization software, saw shares fall as the company embarked on a restructuring strategy that will take some time to realize. Unity plans to divest its unprofitable and lower-margin segments such as professional services and re-accelerate growth rates through product development and new partner distribution strategies. We expect the company to be largely through the transition by the end of 2024, and we believe investors should anticipate the positive outlook for 2025 well in advance.”
General U ranks 24th when we look at Morgan Stanley’s largest overweight stocks. While we recognize U’s potential as an investment, our belief lies in the belief that some AI stocks hold greater promise for delivering higher returns in a shorter time frame. If you’re looking for an AI stock that’s more promising than U, but trades at less than five times earnings, check out our report on 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 consultation with a qualified professional.
