8 High Margin Stocks to Lead in a Sharply Slowing Economy

Many stock investing themes that outperformed during the long U.S. economic expansion are proving to be outmoded given the sharp downshift in the economy, rising costs and thinning corporate profit margins. As a result, "We recommend investors own stocks with low operating leverage and sell companies with high operating leverage," says Goldman Sachs. "The drag on sales from a slowing economy will be less for low operating leverage stocks given they have more stable margins due to higher variable costs as a percentage of revenue," Goldman Sachs observes in a recent report.

This is the second of two stories devoted to that topic. Our previous story explained Goldman's analytical framework and highlighted six stocks in their recommended basket of 50 low operating leverage companies.

In this story, we look at eight more low operating leverage stocks, including AMETEK Inc. (AME), Waters Corp. (WAT), Philip Morris International Inc. (PM), Constellation Brands Inc. (STZ), Lamb Weston Holdings Inc. (LW), DaVita Inc. (DVA), Biogen Inc. (BIIB), and Copart Inc. (CPRT).

8 High-Margin Stocks for Lean Times

(Based on Low Degree of Operating Leverage)

  • AMETEK, 1.7
  • Waters Corp., 2.1
  • Philip Morris, 1.7
  • Constellation Brands, 1.8
  • Lamb Weston Holdings, 1.8
  • DaVita, 2.0
  • Biogen, 1.8
  • Copart, 1.4
  • Median stock in the basket, 1.7
  • Median stock in the S&P 500, 2.6*

Source: Goldman Sachs; *excluding utility and financial stocks.

Significance for Investors

In its latest U.S. Weekly Kickstart report, Goldman says these stocks are ideally suited for an economy that has sharply decelerated while consensus revenue growth estimates for S&P 500 firms have also been cut. As the degree of operating leverage falls, variable costs -- rather than fixed costs -- represent a comparatively greater proportion of total expenses. In a macro environment where sales are likely to decline, companies with low operating leverage will endure a smaller percentage drop in profits for a given percentage decrease in revenues than will companies with high operating leverage.

Stocks with low operating leverage offer superior fundamentals versus their counterparts with high operating leverage, Goldman says. Additionally, low operating leverage stocks have much more attractive valuations than stocks with high levels of forecasted revenue growth, which recently have been one of the investment baskets favored by Goldman.

DaVita's Outlook

Among the eight stocks listed above, the consensus estimates for kidney dialysis center operator DaVita indicate that revenues are expected to increase by just 2%, but EPS by 27% in 2019. Since stocks with low operating leverage should, by definition, normally see percentage changes in profits that are smaller than their changes in sales, this suggests that other factors are in play.

DaVita recently sold its underperforming managed care subsidiary, DaVita Medical Group, to UnitedHealth Group Inc. (UNH), which may be creating some one-time impacts on earnings. DaVita plans to use much of the proceeds to reduce debt and repurchase shares. Share repurchases, in turn, will shrink the equity base and thus increase EPS.

Looking Ahead

Goldman's shift in emphasis from stocks with high revenue growth to those with low operating leverage offers an example of how investors would do well to reassess their portfolio holdings and their strategies regularly. For example, while high relative valuations for stocks with superior projected growth may make them unattractive as new purchases, they may be worth keeping if they were acquired at much lower prices.

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