Amid signs of a slowing economy, decelerating growth in earnings, and soaring stock market volatility, investors might consider a basket of stocks that are "well-positioned to outperform during an uncertain economic environment," according to extensive screening by Goldman Sachs. These stocks offer a "margin of safety" on the basis of "stability and relatively limited downside," Goldman says.
Goldman's basket of 30 "margin of safety" stocks includes these eight: FedEx Corp. (FDX), International Business Machines Corp. (IBM), Walgreens Boots Alliance Inc. (WBA), Equity Residential (EQR), Expeditors International of Washington (EXPD), Lockheed Martin Corp. (LMT), Johnson & Johnson (JNJ), and Archer Daniels Midland Co. (ADM). The stocks in Goldman's basket are drawn from the S&P 500 Index (SPX) and represent a broad range of industries, detailed in the table below. This is the first of two stories that Investopedia will devote to this report, the second to come on Tuesday.
8 'Margin of Safety' Winners
- FedEx: shipping services
- IBM: computer hardware and computing services
- Walgreens: drugstore chain
- Equity Residential: rental apartment real estate investment trust (REIT)
- Expeditors: shipping services
- Lockheed Martin: aerospace and defense
- Johnson & Johnson: pharmaceuticals and healthcare products
- ADM: processed agricultural commodities
Source: Goldman Sachs
Significance For Investors
Goldman's screening method started with calculating an "adjusted forward P/E multiple assuming next twelve month EPS estimates are reduced by 10% from current consensus expectations." Next, Goldman compared the adjusted forward P/E for each stock to its 10-year median P/E and chose those stocks "that would still trade at less than a 10% premium to the historical median if earnings sharply decline." FedEx, Walgreens, and IBM are particularly attractive according to this analysis, with adjusted forward P/E ratios that are below their 10-year medians by 31%, 22%, and 18%, respectively.
But Goldman did not stop there. Stocks passing the primary screen described above also had to pass several others. "In addition, we screen for defensive attributes including strong balance sheets, a non-zero dividend yield, a beta less than the S&P 500 median, and limited popularity among hedge funds," the report continues. Balance sheet strength is measured by the Altman Z-Score, which assesses a company’s likelihood of entering bankruptcy. Stocks with a low beta tend to rise or fall less than the market as a whole, which is another defensive characteristic.
The report notes that, despite “extremely strong earnings growth,” the forward P/E for the S&P 500 has dropped from 18 times projected earnings to 15 times during the past year, for a decline of 17%. As a result, the forward P/E is in just the 61st percentile versus the previous 40 years, they note. They expect U.S. GDP to grow by 1.9% in 2019, leading to a 6% increase in EPS for the S&P 500. Coupled with their forecast that the forward P/E will recover to 16 times earnings, they project 3,000 on the S&P 500 by the end of 2019, for a gain of 27.5% from the open on January 7.
FedEx tops Goldman’s margin of safety list, based on an adjusted forward P/E that is 31% below its 10-year historical median, as noted above. The stock has been battered recently by concerns over a slowing economy and growing international trade tensions, as reported by Bloomberg. However, those who buy into Goldman’s more optimistic view of the economic outlook may see the stock as poised for a positive earnings surprise.
The tradeoff with seeking downside protection from low-beta safety stocks is that the investor is likely to sacrifice upside potential, should Goldman’s optimistic economic and market forecasts prove true. On the other hand, cyclical industrial stocks such as FedEx and Expeditors International may have even more downside, should economic and international trade conditions continue to deteriorate.