Analysts at Goldman Sachs expect the Fed's dovish policy eventually could to lead to a gradual increase in inflation, favoring high-margin stocks with “pricing power.” In its policy statement today, the Fed said it expected 2% inflation in main and core indexes over the next 2 years, in line with its targets. Per a recent report from the investment firm’s research group, a basket of stocks that has posted well above average performance in the past year is even better positioned to outperform in the upcoming period. Analysts add that this group of high-margin stocks is particularly well equipped to perform in 2019 as rising material costs, labor costs and slowing economic growth weighs on corporate profits this year and during an economic downturn.
"Growing margin pressures have driven the outperformance of stocks with high pricing power," wrote Goldman. "Our screen of stocks with high and stable gross margins has outperformed low pricing power stocks by 20 percentage points during the past year."
Goldman screened for stocks with high and stable margins, implying high pricing power. The basket includes Penumbra Inc. (PEN), Amgen Inc. (AMGN), Monolithic Power Systems Inc. (MPWR), National Instruments Corp. (NATI), Citrix Systems Inc. (CTXS), VMWare Inc. (VMW), Eli Lilly & Co. (LLY), Expedia Group Inc. (EXPE) and Xilinx Inc. (XLNX). This is part two of two Investopedia articles covering this particular Goldman research report dated March 15, 2019.
9 Stocks With Pricing Power
(5-Year Average Margin)
- Penumbra Inc. (PEN); 66%
- Amgen (AMGN); 81%
- Monolithic Power Systems Inc. (MPWR); 54%
- National Instruments Corp. (NATI); 74%
- Citrix Systems Inc. (CTXS); 83%
- VMWare Inc. (VMW); 85%
- Eli Lilly & Co. (LLY); 75%
- Expedia Group Inc. (EXPE); 74%
- Xilinx Inc. (XLNX); 69%
Source: Goldman Sachs
Rising Input Costs Put Firms at Risk
Goldman Sachs points out that corporations' profit margins - recently at record levels - are already under increasing pricing pressure.
"Profit margins have experienced substantial negative revisions in recent months, driving a decline in equity EPS estimates," wrote Goldman. "Even with the Fed’s current policy stance, raising prices enough to offset rising input costs has been a challenge for U.S. corporates.”
As margin pressures increase, the equity market is now starting to reward firms with ample pricing power available to maintain their profits. Others that are less capable of passing through costs, either via higher prices or accepting lower profit margins, are beginning to fall out of favor among investors and will continue to do so, per Goldman.
“The outperformance dynamic of stocks with high pricing power has accelerated this year, possibly boosted by the rising probability of Fed pivot in favor of higher inflation and the risks such a shift would pose to corporate profit margins,” read the report.
This movement to favor high pricing power stocks has led Goldman’s list of high-margin picks to beat its list of stocks with low pricing power by 17 percentage points (+13% vs. -4%) since the firm published the list in May 2018. Analysts note that the recent trend follows the historical pattern during periods of profit margin pressure. Since at least 1985, stocks with higher pricing power have typically outperformed when the market perceived an imminent decline in corporate profit margins. On the other hand, during periods of expanding profit margins, such as through 2012 to 2017, investors removed the scarcity premium assigned to strong pricing power firms and stock with more cyclical profit margins outperformed, per the Goldman report.
Cloud Computing Company
Shares of software provider VMware have already significantly beaten the broader market in 2019, up 33.7% year-to-date (YTD) and 47.4% in 12 months, compared to the S&P 500’s 12.4% and 3.9% return over the same respective periods. VMware’s average 5-year margin stands at a whopping 85%, compared to the Russell 1000’s 35% average margin over the period and the basket’s median at 56%.
Last month, the tech firm posted Q4 results in which revenue grew 16% over last year to reach 2.59 billion. Earnings on a per share basis came in at $1.87 for the quarter, also surpassing estimates for EPS of $1.68.
While these companies could continue to rally as investors applaud firms more capable of combating higher costs, a severe downturn would likely weigh on many of these companies. Given the list is sector-neutral, any industry-specific headwinds could also drag down shares.