With interest rates already on the rise, and the Federal Reserve widely expected to announce more rate hikes, Goldman Sachs Group Inc. (GS) has produced a timely report identifying stocks that are thriving in this environment and likely to enjoy continued outperformance. Specifically, they find that investors today should favor stocks with low leverage and strong balance sheets. This is Investopedia's second story on that report and focuses on eight stocks: Surgical Inc. (ISRG), Align Technology Inc. (ALGN), Illumina Inc. (ILMN), Ulta Beauty Inc. (ULTA), Robert Half International Inc. (RHI), Valero Energy Corp. (VLO), Electronic Arts (EA) and Pioneer Natural Resources Co. (PXD).
|Intuitive Surgical||Health Care||33%|
|Align Technology||Health Care||53%|
|Ulta Beauty||Consumer Discretionary||15%|
|Electronic Arts||Information Technology||30%|
|Pioneer Natural Resources||Energy||13%|
|Median S&P 500 Stock||2%|
Source: Goldman Sachs; data through June 7.
Goldman's Strong Balance Sheet Basket includes 50 stocks overall. Our earlier article looked at several of Goldman's picks in the information technology sector. (See also: 7 Stocks That Are Speeding Past the Market.)
Strong Balance Sheets and Growth
As quoted in our earlier article, the report finds that "in contrast with history, many of the companies with the strongest balance sheets today also are the companies with the strongest growth." More specifically, it indicates that "the 6-month daily correlation of our balance sheet factor with our growth factor equals 0.6, ranking in the 98th percentile relative to the last 35 years."
The median stock in the Strong Balance Sheet Basket has a forward P/E ratio of 22 times estimated earnings over the next 12 months, versus 17 times for the median stock in the S&P 500 Index (SPX), and versus 14 times for the median stock in the Weak Balance Sheet Basket. To put this valuation premium in perspective, Goldman looked at PEG ratios, which divide P/E ratios by projected growth rates in earnings. On this basis, they find that "valuation is in line with historical averages," adding, "the relative PEG ratio of strong vs. weak balance sheet firms currently equals 1.5x, ranking in just the 51st percentile since 1980."
On a cautionary note, Goldman believes that the high correlation of strong balance sheets with growth, as described above, represents a potential risk. While they favor both categories of stocks, they warn that this correlation means that "a rotation away from momentum and growth stocks could also weigh on strong balance sheet stocks despite the strong macroeconomic argument for their outperformance."
Meanwhile, based on portfolio data as of March 31, Goldman finds that large-cap mutual funds have a slight tilt toward strong balance sheet stocks. By contrast, "hedge funds generally own larger shares of market cap in weak balance sheet stocks and also hold more weak balance sheet stocks as top 10 positions."