Investors should focus more on earnings growth and less on capital expenditures, says Catalyst's chief investment officer
Google and YouTube parent Alphabet has underperformed the broader market by about 5% since its second-quarter earnings report.
The equity market is not giving Alphabet's stock the credit it's due, as investors ignored booming second-quarter profit growth and chose instead to focus on the uptick in capital-expenditure commitments.
So says David Miller, chief investment officer and senior portfolio manager at Catalyst Funds. In a phone conversation on July 25, Miller expressed skepticism about the market's knee-jerk response to the earnings release and predicted the company $(GOOGL)$ $(GOOG)$ would eventually be rewarded for the investment.
Miller argued in the interview that "perhaps it's not clear with all AI plays how they will exploit their capex and generate returns, but with Alphabet in particular, as well as the other two hyperscalers, Microsoft $(MSFT)$ and Amazon (AMZN), the payback is clearly visible [and] it's easier to quantify how they will exploit it." He added, "As long as the company can demonstrate a reasonable payback period, then the investment case remains compelling."
The minor incremental rise in capital spending - Alphabet lifted its guidance from $195 billion in 2026 to $205 billion - shows a willingness to sacrifice free cash flow for now in exchange for returns within the next two or three years. Miller predicts Alphabet will sustain revenue growth of around 20%, with cloud growth of 60% providing the major impetus, he said. Second-quarter cloud growth of 82% was substantially better than the 60% Miller had been anticipating.
"I don't see a problem paying 24 times forward earnings for a company that can grow high-margin revenue at roughly 20%. From a price-to-earnings-growth perspective, those numbers work," he said.
Following a selloff since last week's report, Alphabet now trades on 21 times forecast earnings through December 2027.
Catalyst is responsible for about $14 billion under management, and in the last year funds managed by Miller like the Catalyst Insider Buying index returned 13%, while the Catalyst Millburn Hedge Strategy delivered 17%. Over the last three years, returns were 23% and 12%, respectively.
David Miller is the CIO and senior portfolio manager at Catalyst Funds
Overall, Miller is overweighting technology stocks in his portfolio, anticipating at least high-teens-percentage earnings growth in the next five to 10 years, but he is cognizant of risks in the sector. Any delays or downsizing to the scheduled IPOs of Anthropic or OpenAI this year would prompt serious weakness in the sector overall, Miller predicted.
Miller noted that high-quality but lower-cost competition from China is a problem for the likes of OpenAI and Anthropic, but he thinks Alphabet is far better positioned. "I think Google has enough distribution that they can catch up with something that's highly competitive. They have so many existing users that they don't need to be at the leading edge or spend significantly more on capex."
Apart from Alphabet, Miller is most confident about Meta Platforms (META), which he reckons will generate 20% earnings growth, enjoying huge benefits from being able to deploy AI to improve targeting. He's also bullish on the chip makers, which he thinks analysts are still treating as a cyclical business (and therefore applying to them unjustifiably low valuations) when, in fact, there is, in Miller's opinion, something much more sustainable about their earnings than was previously the case.
When it comes to playing the semiconductors, Micron $(MU)$ is Miller's preferred vehicle at present. Korean chip makers like SK Hynix $(SKHY)$ and Samsung Electronics (KR:005930) may be cheaper, but, he said, he thinks this is merited owing to the typically lower standard of corporate governance in that market.
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-Jules Rimmer
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