As the S&P 500 trades near record highs in 2019, Goldman Sachs says that a select group of reasonably priced, high-ROE growth stocks will lead the market in the coming months. These include: Baker Hughes (BHGE), which has expected ROE growth in the next 12 months of 47%, followed by MGM Resorts Intl. (MGM) 42%, Iron Mountain Inc. (IRM) 41%, Macerich Co. (MAC) 40%, Devon Energy Corp. (DVN) 41%, Newmont Goldcorp (NEM) 31% and Nordstrom Inc. (JWN) 31%. This is the first of two articles in which Investopedia will look at Goldman's picks.
'Challenging' Outlook for ROE
Goldman says this superior performance will occur despite major pressure on ROE at most companies. "While stocks with low volatility and strong balance sheets still trade more than 2 standard deviations expensive relative to the past 10 years, stocks with high returns on capital carry more reasonable valuations," said Goldman in its latest US Weekly Kickstart report. "We expect investors will continue to assign a valuation premium to stocks with high returns given S&P 500 ROE declined modestly in the 2Q to 18.8% and the outlook for ROE is challenging."
Goldman’s basket of “quality” stocks with high ROE had outperformed the S&P 500 YTD, up 24% vs. 22% for the broader index as of Sept. 20. Goldman expects its ROE growth basket to fare even better as headwinds such as higher input costs, wages, excess inventory and weak pricing weigh on most companies' profit margins.
Goldman’s sector-neutral basket consists of 50 S&P 500 stocks with the highest expected ROE growth over the next 12 months based on consensus estimates. The typical stock in the basket sells at a “modest valuation discount,” and is expected to grow ROE by 12% during the next 12 months as the S&P median stock falls 1%, per Goldman.
Hospitality and entertainment giant MGM, which Goldman highlights, actually has slightly underperformed the market this year, rising 18.3% versus a 19.3% increase for the S&P 500 through Monday morning. But the stock has been on the rebound, rising more than 15% since July. MGM stock jumped in July on earnings that were mostly in line with expectations, spurring optimism about the progress of its MGM 2020 Plan, per Barron’s. Investors have been optimistic about its Macau casinos in Asia as well as major insider buying, which could help the stock to outperform over the next year. “We believe that if MGM can execute on MGM 2020 efficiencies, ramp newer properties (e.g., Park MGM and MGM Cotai), and achieve low- to mid-single digit, same-store cash-flow growth, the lower end of the Ebitda range is not too hard to achieve,” wrote JPMorgan analyst Joseph Greff.
Goldman’s macro model of the gap between the earnings yield and 10-year US Treasury yield suggests the S&P 500 trades at “roughly fair value.” The analysts’ year-end price target of 3100 implies a 3.7% upside and estimates the current forward P/E of 17.5x remains stable. That said, indicators of a global economic downturn, an escalation of trade tensions or other geopolitical factors could drag down the market, putting even these high ROE stocks at risk.
Part two of this series will appear on Tuesday.