America's escalating trade war with China may come at a very high cost and wipe out the 2019 profits of the S&P 500 companies, according to a new study by Goldman Sachs. The firm's comments come as the U.S. just unleashed a new round of tariffs, with more likely to come. Due to these tariffs, Goldman estimates that their 2019 earnings per share (EPS) estimate for the S&P 500 Index (SPX) may fall by about 7% as a result, which would mean no earnings growth versus 2018. Meanwhile, they write, "stocks with high and stable [gross profit] margins have pricing power to withstand rising input prices from tariffs." Their basket of 33 stocks with such pricing power includes these 10, which also appear in the table below: Adobe Systems Inc. (ADBE), National Instruments Corp. (NATI), IDEXX Laboratories Inc. (IDXX), VMWare Inc. (VMW), Flowers Foods Inc. (FLO), Xylem Inc. (XYL), AutoZone Inc. (AZO), Sirius XM Holdings Inc. (SIRI), Expedia Group Inc. (EXPE), and Waters Corp. (WAT).
10 High-Margin Winners
|Stock||YTD Total Return||Average 5-Year Gross Margin|
Source: Goldman Sachs U.S. Weekly Kickstart Report, Sept. 28. Data as of Sept. 27.
Significance For Investors
The 10 stocks listed above are those with the lowest coefficients of variation (CV) in their gross margins during the last 5 years. That is, these 10 have had the most stable profit margins of the 33 stocks in Goldman's basket in recent years.
The median stock in Goldman's basket has a year-to-date (YTD) total return (dividends included) of 17% and an average 5-year gross margin of 54%. Goldman drew the constituents of this basket from the members of the Russell 1000 Index, excluding companies in the financial, real estate and utilities industries, for which the comparable figures are 8% and 33%, respectively.
""The market typically rewards companies with high margins when the outlook for corporate profitability worsens," Goldman says in its report. They add, "companies with high pricing power are well-positioned to pass through input cost pressure to consumers, preserving high margins." In their analysis, Goldman's analysis hinges on the assumption that "high and stable gross margins are typically an indicator of high pricing power."
Additionally, Goldman compared their basket of 33 stocks with high and stable gross margins to its polar opposite, a group with low and variable gross margins. The YTD performance gap between the two groups has been widening through 2018, reaching an 18 percentage point advantage for the high and stable group as of Sept. 27.
Goldman estimates that S&P 500 EPS will be $159 in 2018 and $170 in 2019. The scenario in which 2019 EPS falls by nearly 7% from $170 to $159, and thus is unchanged from 2018, assumes a 25% U.S. tariff on all imports from China. The significance of tariffs for U.S.-based companies as a whole lies in the fact that 15% of their cost of goods sold (COGS) comes from imports. Among the large cap, heavily globalized companies in the S&P 500, the figure is even higher, with 30% of their COGS coming from imports.
Goldman warns that business conditions and competitive dynamics are in a constant state of flux, and thus that today's leaders may become tomorrow's laggards. For example, they note that the household and personal products industry group had a long history of high and stable gross margins, but the median stock in this group has seen its gross margin erode by 75 basis points during the past 2 years.
Also, there is no guarantee that stocks meeting Goldman's criteria will outperform, especially in a limited time period. For example, of the 33 high gross margin stocks in their basket, 10 have posted YTD 2018 total returns that are below the median for the Russell 1000 excluding financials, real estate and utilities, and 6 of these have registered negative YTD total returns.