Stock investors now face a greater challenge in finding shares of companies with upside potential for return on equity (ROE) growth as S&P 500 ROE peaks. Moving forward, analysts at Goldman Sachs expect thinning profit margins, and the wearing off of the positive impact of the Trump administration's tax cuts, as resulting in flat ROE growth for the broad index in 2019. That being said, analysts indicate that there are still plenty of stocks with superior ROE growth in a position to outperform the market in the upcoming period.
Goldman has screened the market and created a sector-neutral basket of 50 stocks that it believes can continue to lead the market by posting the highest ROE growth over the next year.
"The basket has outperformed the S&P 500 by 5 pp YTD, consistent with other growth themes," wrote Goldman analysts in the firm’s U.S. Weekly Kickstart Report dated March 15. “The median stock in the list is expected to see ROE improve from 16% to 19% during the next 12 months,” read the report, noting that the basket outperforms especially well when growth is scarce.
This is Investopedia’s second of two stories on high-ROE stocks. (Read part one here.)
7 High-Return Stocks as ROE Peaks
Source: Goldman Weekly Kickstart Report, March 15, 2019
Limited Potential for ROE Growth in 2019
According to Goldman, ROE growth is peaking and getting leaner. ROE reached 18.6% in 2018, its highest level since 2000. While last year’s ROE growth was fueled by factors including Trump’s massive corporate tax cuts, which cut the effective tax rate from 22% in 2017 to 17% in 2018, Goldman is less optimistic about broader S&P 500 ROE gains this year. New threats to companies include forecasts for flat margin growth through 2020, with risks tilted to the downside, as well as heightened cost pressures. Goldman likes companies with high and stable gross margins, making them more likely to pass through higher input costs and outperform. The firm also notes that while investors punished companies with high leverage and borrow costs in 2018, it does not expect that trend to continue in 2019, thanks to the Fed’s more dovish stance.
Legacy Tech Titan Cisco
Networking giant Cisco has seen its shares gain 23.4% YTD, compared to the S&P 500’s 12.7% increase over the same period. ROE growth is at 40%, compared to the broader index at negative 4%.
The tech company’s earnings have been fueled by a successful transition away from legacy hardware businesses, towards high-growth industries like the Internet of Things (IoT), cybersecurity and software. The company has been on an acquisition spree as it doubles down on its restructuring. Its strong free cash flow has allowed the San Jose, Calif.-based company to return billions of dollars per quarter to shareholders in the form of dividends and share buybacks. After posting several consecutive quarters of revenue growth above expectations, guidance for the upcoming period has confirmed a continuation of this trend.
Despite positive drivers for the strong ROE stocks in Goldman’s basket, not all of the 50 stocks in the basket are doing well YTD, with analysts indicating that 72% outperforming. Given some stocks in the basket, such as TripAdvisor Inc. (TRIP) and Coca Cola Co. (KO), are lagging the broader market, investors should be sure to not pick these names blindly.