As interest rates rise, highly leveraged companies are seeing their profit margins pinched. By contrast, the shares of companies with strong balance sheets already are outperforming their heavily indebted peers by 8 percentage points year-to-date, according to research by Goldman Sachs Group Inc. (GS). "Strong balance sheet stocks have historically outperformed weak balance sheet stocks during environments of rising leverage," Goldman says in its latest U.S. Weekly Kickstart report. They add, "Strong balance sheet stocks appear primed for outperformance whether economic growth remains strong or falters." This is the first of two articles that Investopedia will devote to Goldman's report.
Among the 50 stocks in Goldman's Strong Balance Sheet Basket are Skyworks Solutions Inc. (SWKS), Adobe Systems Inc. (ADBE), Intuit Inc. (INTU), MasterCard Inc. (MA), ANSYS Inc. (ANSS), Cognizant Tech Solutions Corp. (CTSH), and Texas Instruments Inc. (TXN). Goldman's findings are especially timely, given that the Federal Reserve is widely expected to announce another interest rate hike Wednesday.
|Median S&P 500 Stock||2%|
Source: Goldman Sachs; data through June 7.
Goldman analyzed the stocks in the S&P 500 Index (SPX) by computing Altman Z-scores for each, a metric that combines the readings from five financial ratios to predict the likelihood of bankruptcy. The standard interpretation of this data is that stocks with scores of 3.0 or more are unlikely to go bankrupt. The median stock in the S&P 500 has a score of 3.4, the median stock in Goldman's Strong Balance Sheet Basket has a score of 9.0, and the seven stocks listed above have scores ranging from 10.1 for Cognizant to 23.0 for Skyworks.
The Fed: 'Much More Hawkish'
Goldman's economists expect that the Federal Reserve Board will increase the Fed Funds Rate by 25 basis points on Wednesday, to a target range of 1.75% to 2.00%. They note that the futures market already is assigning a 91% probability to this rate hike.
Going forward, however, they believe that the "expected Fed hike path is much more hawkish than futures market pricing." The futures market anticipates that the Fed will hike rates once more in 2018 after this week, and twice in 2019. Goldman, by contrast, projects two more hikes in 2018 after this week, and four in 2019. They base this forecast on their observation of tightening financial conditions per five key financial indicators: rising yields on the 10-Year U.S. Treasury Note, a strengthening U.S. dollar, widening credit spreads, a drop in stock prices and the Fed's decision to raise rates in March.
Strong Balance Sheets and Strong Growth
For the median S&P 500 company, net debt to EBITDA ratio is at the highest level on record, Goldman finds. Against a background of historically low interest rates, companies with weak balance sheets took advantage of cheap financing and outperformed their less indebted rivals. "Since January 2017, however, firms with strong balance sheets have outperformed," Goldman writes, adding, "We expect this recent trend will continue as monetary policy normalizes."
If economic growth slows, leading to a slower increases in interest rates, Goldman notes that weak balance sheet stocks nonetheless will have declining interest coverage ratios. By contrast, the write, "In the past, the periods of sharpest strong balance sheet outperformance have occurred alongside slowing economic growth and weak equity returns." Moreover, they add, "In contrast with history, many of the companies with the strongest balance sheets today also are the companies with the stongest growth."
The second story on this topic will appear in Investopedia on Wednesday, June 13.