10 Bargain Blue Chips Seen Surging As Fed Lowers Rates

A screen of dozens of companies shows that low-valuation, high-leveraged stocks have led the market in recent months and are poised to outperform. Goldman Sachs U.S. Weekly Kickstart report published July 26 noted that Fed easing has led P/E multiples to jump from 14 times to 17 times, accounting for almost 95% of the S&P 500’s 20% return year-to-date (YTD). 

In anticipation of the Federal Reserve cutting interest rates, stocks with weak balance sheets could continue to benefit disproportionately. These firms should also gain on a moderate increase in the rate of U.S. economic growth. Goldman’s list of stocks expected to post outsized returns in this environment includes AT&T Inc. (T), DISH Network Corp. (DISH), Hilton Worldwide Holdings (HLT), Kinder Morgan Inc. (KMI), IQVIA Holdings Inc. (IQV), Becton Dickenson (BDX), Ford Motor Co. (F), Delta Air Lines (DAL), Xerox Corp. (XRX) and Global Payments (GPN). 

Stockers With Higher Corporate Leverage Outperform

An environment of lower interest rates is viewed as granting more capacity for companies to invest in growth and return cash to shareholders. S&P 500 investments for growth, including capex, R&D, and cash M&A grew by a median of 8% during the three months following the start of the past four Fed cutting cycles. Stock buybacks are on track for a 26% year-over-year (YOY) increase. Meanwhile, payout ratios have jumped, cash balances have fallen and corporate leverage is at an all-time-high. 

“Stocks with weak balance sheets should benefit from a modest acceleration in the pace of U.S. economic growth," wrote Goldman in the new report. "Weak balance sheets trade at a significant discount based on forward P/E to stocks with strong balance sheets (15x vs. 25x) and are expected to generate equivalent EPS growth during 2019 (+7%)." 

Higher leveraged stocks underperformed those with strong balance sheets by 24pp (-3% vs. 21%) from the start of 2017 to the end of 2018 as the Fed tightened monetary policy. More recently however, as the Fed shifted to a more dovish stance, and expectations for Fed easing have strengthened, weak balance sheets have outperformed strong balance sheets. Since the start of June, the basket of higher leveraged companies outperformed by 450 bp (+12% vs. +8%). 

Hilton Worldwide, Delta

Multinational hospitality company Hilton Worldwide, with a $28 billion market value, is expected to see 2019 earnings per share (EPS) growth of 34%. The company’s net debt to EBITDA stands at roughly 4 times, and its Altman Z-Score, which is more related to the sector’s average and indicates the likelihood of bankruptcy, is a 1.4. 

Altanta, GA-based airline Delta has seen its stock jump 27%, outperforming rivals such as American Airlines Group Inc. (AAL) and Southwest Airlines Co. (LUV). Delta stock’s rally has been partially aided by the fact that the company did not buy any of Boeing Co.’s (BA) 737 MAX aircraft, which has forced other carriers to cancel thousands of flights and lose hundreds of millions of dollars in the process. The consensus estimate calls for a 20% increase in 2019 EPS. The company’s net debt to EBITDA is 1.5 times and its Altman Z-score is 1.4. 

Looking Ahead

As the Fed gears up for its meeting next Wednesday, market watchers are almost certain that another rate cut is coming. Goldman analysts peg the chance of a 25bp reduction in rates at 80% and a 50 bp cut at a 20% probability. This should continue to support the trend toward buying shares of companies with high corporate leverage. While Fed easing historically increases share repurchases and promotes a spike in corporate leverage, for the first time in the post-crisis period, companies are returning more cash to shareholders than they are generating in free cash flow, per Goldman. And unless earnings growth accelerates materially, these firms are likely to continue to fund their spending by using up their cash balances and increasing leverage.

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