Down around 6% from its all-time high, the S&P 500 has been trading in about the same range for nine months. Tech stocks led the S&P 500 out of the pandemic bottom, and cyclical companies drove it higher throughout 2021. While I don't know how long the index will trade in the current range, I do have an idea about which stocks will lead the market to its next record run.
After tech sector valuations reached record highs in the first nine months of 2021, the stocks in the sector sold off despite solid business prospects in the fourth quarter of 2021. This sell-off dragged down many stocks, including two large enough to lead the market higher: Alphabet (GOOG -2.17%) and Nvidia (NVDA 4.25%). Both companies are leaders in their industries but still have plenty of market share to capture, giving them room to grow.
Image source: Getty Images.
Alphabet
Alphabet is the parent company of dominant businesses like Google, YouTube, and the Android smartphone operating system. It also has a thriving cloud-computing segment, although it's third in industry market share. Whenever Alphabet gets involved, however, success seems to follow.
In 2021, Alphabet's total revenue rose 41%, and profits grew at an 89% clip over the prior year. This increase allowed Alphabet to repurchase more than $50 billion in stock, reducing its shares outstanding by about 2%. During the company's fourth-quarter conference call, CFO Ruth Porat said that the company views these repurchases as valuable to shareholders and will continue the buyback program.
To power Alphabet to new highs will require sustained business growth from both old and new segments. While Alphabet expects to see less revenue from the Google Play Store segment due to fee restructuring, it is investing heavily in its Google Cloud division to try and capture more market share. With consistent advertisement spending from its clients, Alphabet's core business of Google and YouTube advertising has plenty of room to run as well.
Trading at less than 25 times earnings, Alphabet is dirt cheap and trades for less than typical consumer staples stocks like Costco (46) and Proctor & Gamble (28). As a result, Alphabet's valuation can quickly rise to a more common tech stock valuation like Microsoft (30) or Apple (28). At Alphabet's current 23 times earnings, this would imply a 30% upside if its valuation would rise to 30 to match Microsoft. Even if this doesn't occur, Alphabet's consistent growth will translate to higher earnings dropping the valuation further. A stock's valuation can only drop so far before investors pile en masse to take advantage of the sale price and Alphabet isn't too far from this threshold.
When Alphabet reports earnings on April 26, investors will gain insight into how the company is dealing with inflation and geopolitical issues. A company as experienced as Alphabet should be able to handle any problems and report solid results with an upbeat outlook.
Nvidia
In 1999, Nvidia invented the GPU (graphics processing unit) to process the calculations necessary for real-time graphics shading. Later, engineers realized the GPU could be used in many other disciplines -- like data centers and artificial intelligence. The GPU has become a staple in every gaming system and supercomputer, with Nvidia's products used in top-of-the-line builds.
TOP500 keeps track of the 500 most powerful supercomputers on earth and found that Nvidia's components were used in 355 (71%) of builds. Furthermore, 90% of new builds utilized Nvidia's products. GPUs are essential building blocks for the digital future, and Nvidia stands to benefit from their implementation.
The fiscal year 2022 (ending Jan. 30, 2022) was wildly successful for Nvidia, with revenue rising 61% year over year to $26.9 billion. Like Alphabet, its net income grew faster than revenue at a 71% pace. Its data center division was the star of the show, with Q4 revenue growth of 71% over the prior year.
In Q1 FY2023, management expects the data center division to continue driving growth with the largest segment -- gaming -- boosting results. Revenue is expected to be about $8.1 billion, resulting in 43% quarterly sales growth over the year-ago period.
Data centers are far from being built out, giving Nvidia a large market to capture. Additionally, it has pioneered the Omniverse -- Nvidia's metaverse for 3D collaboration. The Omniverse allows engineers to create digital twins and understand how changing one factor affects the entire system without testing it out in the real world. New workers can train in the Omniverse on digital products rather than potentially making a mistake in a real one.
Image source: Getty Images.
At 60 times earnings, Nvidia is a bit expensive. However, with the business opportunities in front of it, Nvidia's stock has a lot of potential. Should these expectations come to fruition, Nvidia's stock can assist Alphabet in powering the market to new highs.
Alphabet and Nvidia are the third and seventh largest companies on the S&P 500 index. Together, they make up 5.8% of the index, allowing them to push the market higher as they execute. I like these stocks to do just that with solid business prospects ahead.
