Against a background of decelerating GDP growth in the U.S. and across the globe, Goldman Sachs recommends stocks with high, stable profit margins and low operating leverage. They add that stocks with fast sales growth, until recently one of their favored investment themes, now are overpriced relative to the market. By contrast, stocks with low operating leverage are trading at a valuation discount.
"In the current macro environment, we recommend investors own stocks with low operating leverage and sell companies with high operating leverage," Goldman says in their latest U.S. Weekly Kickstart report. "Stocks with low operating leverage also have attractive fundamentals relative to stocks with high operating leverage," they add.
Among the 50 stocks in Goldman's low operating leverage basket are these six: Twenty-First Century Fox Inc. (FOXA), CBS Corp. (CBS), Hilton Worldwide Holdings Inc. (HLT), Starbucks Corp. (SBUX), Diamondback Energy Inc. (FANG), and TransDigm Group Inc. (TDG). This is the first of two articles that Investopedia will devote to that report, the second to come on Thursday afternoon.
6 Recession-Resistant Stocks
(Based on Low Degree of Operating Leverage)
- Twenty-First Century Fox, 1.7
- CBS, 1.8
- Hilton, 1.6
- Starbucks, 1.8
- Diamondback Energy, 1.5
- TransDigm, 1.3
- Median stock in the basket, 1.7
- Median stock in the S&P 500 Index (SPX), 2.6*
Source: Goldman Sachs; *excluding utility and financial stocks.
Significance for Investors
Goldman calculated each company's degree of operating leverage as (1) revenue minus variable costs, divided by (2) revenue minus both variable and fixed costs. In normal circumstances, the lowest possible value for the degree of operating leverage is 1.0, indicating that all the company's costs are variable.
Stated differently, companies with high operating leverage have costs that are largely fixed. As a result, when revenues rise, a large proportion of the increase falls directly to the bottom line. By contrast, companies with low operating leverage have cost structures that are quite variable, rising or falling in tandem with the amount of sales or the level of business activity.
However, in a period of economic slowdown when sales may be declining, the situation is reversed. Low operating leverage companies should endure less severe percentage declines in profitability since their expenses should fall as well. On the other hand, high operating leverage companies will have significant costs that remain despite the drop in revenue.
Comparing their basket of 50 low operating leverage stocks to their basket of 50 high operating leverage, Goldman finds the former to be attractive across several metrics. These are: a valuation based on forward P/E ratios that is 24% lower (15x vs. 19x); a median net profit margin that is almost twice as large (17% vs. 9%); and a median return on equity (ROE) that is more than 50% higher (29% vs. 18%).
Goldman notes that, since 2011, their basket of high revenue growth stocks has tended to outperform the S&P 500 in periods of sharply decelerating economic growth. However, they do not favor this strategy right now since these stocks are trading at 23% premium to the S&P 500 based on forward P/E (22x vs. 17x). Note that Goldman's P/E comparisons are affected by rounding.
Diamondback Energy is by far the standout in the basket, with projected growth in 2019 of 95% for sales and 30% for EPS. The median target price from 34 analysts covering the stock is $146, per CNN, which would be a 38% gain from the Feb. 27, 2019 close. Diamondback delivered earnings and revenue disappointments in 4Q 2018, but has issued guidance calling for a 27% increase in output in 2019, per Zacks Equity Research. Diamondback acquired rival oil exploration and production company Energen Corp. in 4Q 2018, which may be skewing the growth comparisons.
While Goldman's low operating leverage basket may outperform against the background of a slowing economy, it probably will not do very well if economic growth stabilizes and the bull market continues. Moreover, even in a slowing economy, its outperformance may consist of falling less than the broader market, rather than actually going up. Indeed, 19 stocks in the basket are projected to suffer declining sales in 2019.