The tech-heavy Nasdaq Composite plunged 33% in 2022, coming off its worst year since 2008. After tech's heady days earlier in the pandemic, inflation reared its head for the first time since before the Great Financial Crisis, and the Federal Reserve raised interest rates at its fastest pace in decades.
While some may be expecting a big bounce-back from the most beaten-down tech stocks (which have fallen the farthest), lots of uncertainty remains. We could have a recession; if one is avoided, interest rates could stay higher for longer. That's why tech conglomerates Amazon (AMZN -1.35%), Alphabet (GOOG -1.80%) (GOOGL -1.82%), and Microsoft (MSFT -1.96%), having fallen between 28% and 50% in 2022, could be growth investors' best bets for a tech rebound in 2023.
Proven profitability
While it's possible inflation will fall and rates will come down, it's also possible higher rates could be here to stay for a while. If rates do fall, it could mean the Fed has pushed us into recession. A "soft landing," in which inflation and interest rates moderate without a recession, is still possible, but investors are likely to be in a "risk-off" mode until there's a resolution. And in the optimistic scenario in which a recession is avoided, interest rates might stay higher than they were between the Great Financial Crisis of 2008 and the COVID-19 pandemic.
That means investors may demand more profitability from their stocks than they have over the last 15 years. While a lot of growth tech stocks with huge gains over the past few years have never actually earned a profit, Amazon, Microsoft and Alphabet have each demonstrated big profitability in their core businesses before. While margins have recently come under pressure, much of that can be attributable to the macroeconomic environment -- not their competitive positions.
So if the economy stays strong but rates stay high, these three tech giants could fare much better than unprofitable growth stocks that need ultralow rates to fund their growth and garner high valuations.
Amazon down 50%: Three major headwinds could reverse
There is a train of thought that Amazon is not very profitable, but it's highly likely that that's by choice. Amazon has generally attempted to operate around breakeven every year, reinvesting profits from its core businesses into growth ventures.
The company does break out its Amazon Web Services operating margin, which usually lands in the high-20% to low-30% range. Meanwhile, Amazon's digital ad business and third-party e-commerce revenue are likely high-margin as well. And if you remember the tech bubble bursting in the early 2000s -- the last time Amazon went into cost-cutting mode, when it was just a first-party retailer -- its operating margin reached 6.4% by 2004.
Prior to and during the pandemic, Amazon's overall profits were beginning to inflect upwards. But the company massively overspent while building out infrastructure during the pandemic. It was also hit by two other headwinds in the first nine months of 2022: rapidly rising fuel prices, which raised e-commerce delivery costs and the costs to run its cloud data centers, and the rapidly rising dollar, which lowered sales made in foreign currencies.
But all those headwinds have shown signs of reversing. CEO Andy Jassy is rationalizing Amazon's logistics footprint, and cutting noncore projects. And he recently announced over 18,000 planned layoffs, reversing some of the excess hires made over the past two years.
In addition, oil and natural gas prices have meaningfully declined over the past few months, as has the U.S. Dollar Index.
With headwinds to profits reversing, and e-commerce and cloud having easier sales comparisons in 2023 than they had in 2022, Amazon's earnings could surprise to the upside through the year. Perhaps that's why Amazon was actually named one of Barron's top 10 picks for 2023.
Alphabet: Cash-rich with a cheap stock
You wouldn't think a company like Alphabet would deserve only a market-average valuation, with its dominant Google Search engine and myriad side ventures all centering around big data and artificial intelligence technology.
Alphabet has been hammered over concerns about the digital advertising market in case the economy heads into recession. However, the company also has a lot of net cash on its balance sheet -- over $100 billion worth -- and after its 2022 downdraft, it trades at the cheapest valuation of these three stocks, at just 17 times earnings.
Moreover, those profits have been depressed by Alphabet's cloud division losses as well as those at its "other bets" segment. That makes its core advertising businesses across Google Search, YouTube, ad networks, and Android even cheaper.
Meanwhile, it's hard to imagine that Alphabet's high-growth cloud division doesn't have any value. And while "other bets" may be questionable, their value is likely not negative. Furthermore, Alphabet could likely pull back on those expenses if desired.
While fuel and infrastructure costs aren't as big a deal for Alphabet, it was perhaps more affected by the strong dollar, with currency accounting for a 5-percentage-point headwind to growth last quarter.
The strong dollar has reversed recently, and while the advertising industry has entered a down cycle, eventually there will be another up cycle; meanwhile, Alphabet still has a dominant leading position in Search and YouTube. And while Google Cloud isn't profitable yet, it actually outgrew the other cloud platforms last quarter. Given that AWS margins are around 30%, it's highly likely Google Cloud will eventually be profitable as it scales further.
One potential risk has emerged, as OpenAI recently unveiled the ChatGPT chatbot engine that some say could one day challenge Google Search. However, as ChatGPT just opened to the public on Nov. 30 and its computing costs are sky-high, it doesn't seem to be a challenge in the near term.
Even if ChatGPT does eventually pose a threat to Alphabet, it's only another reason to own Microsoft, which is an investor in the new chatbot and might use it in some of its products.
Microsoft: Highly defensive with underrated growth
Even Microsoft, perhaps the most diverse and defensive of the three, fell nearly 29% in 2022. It's not often that a company like Microsoft, which has a higher bond rating than even the U.S. government, falls that much, making the stock attractive now.
Like Alphabet, Microsoft was also hammered by a strong dollar in the third quarter. And now, worries about cloud software growth are coming to the fore.
Still, Microsoft is the most profitable of the bunch, owing to its various monopolistic or oligopolistic businesses that are growing at scale, including Windows, Office, Dynamics, Azure, LinkedIn, Xbox, and others. Under CEO Satya Nadella, Microsoft's already-high operating margin has expanded by about 15 percentage points over the past decade, to nearly 43% today:
MSFT EBIT Margin (TTM) data by YCharts. EBIT = earnings before interest and taxes.
What's great about Microsoft is that although the company already operates at massive scale, it's not resting on its laurels. Its recent plans to incorporate ChatGPT into its Bing search engine, and its attempt to buy Activision Blizzard despite the regulatory risks, show that Microsoft isn't being shy in making bold attempts to grow even larger.
Cloud and artificial intelligence (AI) growth businesses should power through a recession. Image source: Getty Images.
All three are in the best growth business for the 2020s
The common link among Amazon, Alphabet, and Microsoft is that they're part of the cloud infrastructure oligopoly. Although cloud growth slowed late last year, an economic downturn may only accelerate companies moving to the cloud in the long run, as it saves them cash on building their own data centers.
Businesses moving workloads to the cloud are akin to buildings moving from on-site generators to plugging into the electric grid. And this virtual "grid" enables cutting-edge innovation that otherwise wouldn't be possible, with all three companies developing artificial intelligence applications that could grow their businesses even further.
While some analysts have recently predicted cloud growth will slow next year, research company Gartner projected in an October report that cloud infrastructure growth will accelerate from 27.3% this year to 29.8% next year. Over the long term, Allied Market Research believes the cloud infrastructure market will grow an average of 25.3% annually between 2021 and 2030. That's a really high growth rate to keep up for 10 years.
Even if the current slowdown persists, that would seem to be a near-term cyclical issue. Over the long term, the cloud infrastructure-as-a-service (IaaS) sector looks like a large market in which only these three players are able to meaningfully compete, making all three solid choices for the rest of the 2020s.
Amazon, Alphabet, and Microsoft share high historical and underlying profitability, profit expansion opportunities in 2023, and exposure to the cloud IaaS market. These three names not only may be the most defensive tech stocks in 2023, but could also have the best chances to rebound.
