Stock market downturns come and go, but the opportunities they present investors can result in gains that last a lifetime. Take Alphabet (GOOG +0.44%) (GOOGL +0.66%) for example. The stock is down more than 35% from its all-time high, yet its business is going through a cycle it has experienced multiple times.
Investors need to be willing to scoop up these massive opportunities, as the impact a stock recovery can have on a portfolio is impressive. The market is ripe with opportunity, and Alphabet is one of the top stocks.
A normal business cycle
Companies that make money from advertising are naturally exposed to the impact of the broader business cycle. When the economy slows and businesses tighten up their spending, advertisement budgets are among the first areas to get cut, primarily because of how easy it is to reduce that spending compared to canceling projects or laying off workers. Nearly 80% of Alphabet's revenue is derived from advertising, so it is severely influenced by this cycle.
This trend was displayed in Alphabet's Q3 earnings report: Its advertising revenue rose only 2.5%. YouTube took a step back in its advertising segments, with revenue falling 1.9% year over year. However, ad sales for Google Search grew by 4.3%.
NASDAQ: GOOG
Key Data Points
Even though those levels of advertising growth aren't as strong as investors want to see, they are still better than those of many of Alphabet's advertising peers. Still, Alphabet trades at a bargain valuation of 18.7 times earnings -- cheaper than the S&P 500's average of 20.6.
So why is Alphabet trading at a discount to the market when it's a clear market leader?
Its outlook.
Investors expect the U.S. economy to weaken further, which would lead to further declines in ad spending. However, Wall Street analysts on average disagree with this assessment: Their consensus projection is that Alphabet will grow its sales by 8% in 2023. But its earnings per share are projected to fall to $4.72 in 2023. That gives Alphabet's stock a valuation of 19.9 times forward earnings, which is still cheaper than the broader market.
What will happen after 2023 is anyone's guess, but after previous economic downturns, Alphabet's revenue has recovered substantially.
GOOG Revenue (Quarterly YoY Growth) data by YCharts
So if Alphabet's revenue growth recovers in a few years, its profits will likely rise and either decrease its already cheap valuation or cause the stock price to rise.
However, revenue growth doesn't always translate into profits, and if Alphabet doesn't do something about its hiring habits soon, it could find itself in a tough spot.
Alphabet's employee count has exploded
Alphabet's hiring pace has been remarkable over the past year -- nearly 37,000 more people work at Alphabet now than did just a year ago. For reference, as of the end of Q3 2021, Alphabet employed 150,028. At the end of Q3 2022, it employed 186,779, a 25% increase. However, it's unknown how many of those employees truly added value.
In Alphabet's most recent earnings call, an analyst asked if management had any performance indicators or analytics to justify this hiring spree. Management didn't indicate if they did; instead, they skirted the issue with the response that "talent is the most precious resource." While I agree that talent is an essential resource, I don't think any company needs that many workers to improve a product, especially if it only results in company-wide revenue growth of 11%.
Management also noted that in Q4, it planned to slow the pace of hiring to about half of what it was in Q3 -- indicating that about 6,500 new employees would be added. Controlling its compensation expenses will be vital, as Alphabet's operating margin has been trending in the wrong direction over the past year.
GOOG Operating Margin (Quarterly) data by YCharts
But I don't think this is a great reason not to purchase the stock. Alphabet remains a top investment due to its market dominance in search advertising. Additionally, its Google Cloud cloud infrastructure business continued to deliver solid results, with revenues rising by 38% year over year in Q3.
Management understands it needs to moderate its hiring pace. As it does so, Alphabet's operating margins should improve. However, when the economy begins to recover, Alphabet's revenue streams should grow substantially, bringing more profits with them. That should create a massive positive catalyst for the stock.
Because of this, investors should buy Alphabet stock now, while it's trading at a discount to the broader market. Don't miss the opportunity.
