Is NVIDIA Corporation (NASDAQ:NVDA) The Best Morgan Stanley Overweight & Quality Stock?

We recently made a list of Morgan Stanley’s Best Overweight & Quality Stocks: Top 25 Stocks. In this piece, we will look at where NVIDIA Corporation (NASDAQ:NVDA) 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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NVIDIA Corporation (NASDAQ:NVDA)

Number of Hedge Fund Holders In Q2 2024: 179

Average Analyst EPS % Revision: 4.2%

NVIDIA Corporation (NASDAQ:NVDA) is the GPU designer that has led the surge in Wall Street surrounding artificial intelligence. Its GPUs are the mainstay of the AI industry, as they are the most advanced in the world for computing AI workloads. Additionally, another key to NVIDIA Corporation (NASDAQ:NVDA)’s meteoric rise is its GPUs’ ability to power accelerated computing which enables heavy duty non AI workloads to be processed faster despite the physical limitations of CPU manufacturing. NVIDIA Corporation (NASDAQ:NVDA) also allows GPU users the ability to control their chips to a greater extent through CUDA, and its success depends on maintaining market dominance. As long as NVIDIA Corporation (NASDAQ:NVDA)’s GPUs are needed by most companies, and no viable rivals or alternatives exist, the firm can continue to grow. Morgan Stanley believes that the firm is capable of generating $10 billion in revenue in Q4 alone courtesy of its Blackwell GPUs due to strong competitive advantages.

Baron Funds mentioned NVIDIA Corporation (NASDAQ:NVDA) in its Q2 2024 investor letter. Here is what the fund said:

“More recently, however, we’ve entered the period of doubts and questioning, some of which is real and normal in the first stages of a new paradigm, and some of which is prompted by short sellers. Given the explosive returns of NVIDIA and other AI leaders, AI bears and fear mongers have been comparing the current AI market winners with the internet bubble of the late 1990s/early 2000s, and NVIDIA’s stock move today with Cisco’s back then. First, while many stocks were trading at nosebleed valuations and on made up metrics (such as price per eyeballs) before the bursting of the internet bubble, as we’ve said many times, the internet proved to transform our world and create the digital age we are now living in. Second, while NVIDIA’s stock price inflection has been nothing short of unprecedented for a company of its size, it was fueled almost entirely by explosive growth in revenues, earnings, and cash flows– not multiple expansion. Over the last 12 months, NVIDIA’s stock has effectively tripled, but its forward P/E multiple has remained essentially flat, because NVIDIA blew away Wall Street expectations despite being covered by over 60 sell-side analysts, who have increased their forward projections every single quarter. In my career, the only comparative analogue is when Apple first introduced the iPhone and stunned Wall Street with its growth. In contrast, most of Cisco’s move in the late 1990s was due to multiple expansion. At its peak, Cisco traded at a P/E ratio over 130 times, more than quadruple its five-year average of 37 times. At the end of the second quarter, NVIDIA traded at a P/E ratio of 40 times, equal to its five-year average, and at a P/E to growth (or PEG) ratio for 2025 of 0.8 times, as consensus expectations are for NVIDIA to grow earnings per share 40% next year.

Moreover, investor concerns have arisen about the financial impact AI is having and whether surging capital expenditures (capex) across the technology landscape, particularly the large cloud players (Microso, Google, Amazon, and Meta), known as the hyperscalers, will be justified and earn reasonable returns on invested capital (ROIC). First, the adoption and penetration of new technology typically traces a classic S-curve–or more precisely, in our view, a series of S-curves or phases. For at least the past year and a half, we’ve been in what might be called the AI infrastructure- build phase – building the AI factories, as NVIDIA CEO Jensen Huang has articulated it, and this phase has been dominated by the infrastructure- layer players – the accelerated computing chips suppliers like NVIDIA and Broadcom, as well as data center, cloud infrastructure and energy companies. The hyperscalers, other enterprises, and sovereign entities investing ahead understand that if you want to be in the AI game, you must invest now – build the infrastructure, build the factories – or else you’ll find yourselves disrupted on the sidelines or playing catch up in the biggest game, the most important race in a technology generation. Only those who invest today even have the chance to be the winners of the future.”

Overall NVDA ranks 6th when we look at Morgan Stanley’s top overweight stocks. While we acknowledge the potential of NVDA 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 NVDA but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

Disclosure: None. This article was originally published on Insider Monkey. All investment decisions should be made after consulting a qualified professional.