The S&P 500 Index (SPX) this year is expected to post robust return on equity (ROE) this year, aided by tax cuts which will offset rising costs, according to Goldman Sachs Group Inc. (GS). These nine stocks are among those that Goldman expects to enjoy the fastest ROE growth: Caterpillar Inc. (CAT), Charles Schwab Corp. (SCHW), Deere & Co. (DE), MetLife Inc. (MET), Microsoft Corp. (MSFT), Morgan Stanley (MS), Phillips 66 (PSX), Starbucks Corp. (SBUX) and Varian Medical Systems (VAR).
Identifying High ROE Growers
Goldman has 50 stocks in its ROE growth basket, with at least one from each of the 11 S&P 500 sectors. Their analysts forecast these to have the fastest ROE growth during the next 12 months (NTM). Some of these stocks have been recommended by Goldman for other reasons, and three (MetLife, Caterpillar and Deere) were in their January "Conviction List" of top picks. (For more, see also: 10 Stocks That Can Outperform in 2018: Goldman.)
The median stock in the ROE growth basket has a forward ROE (on an NTM basis) of 28% and an ROE growth rate of 23%. Among the S&P 500 stocks covered by Goldman's analysts, the respective medians are a 20% forward ROE and a 1% ROE decline, respectively.
Using Starbucks as an example of the calculations, the ROE based on last 12 month (LTM) trailing earnings was 60%, and Goldman's projected improvement to 80% based on forward earnings thus represents a 34% increase ((80% / 60%) - 1).
For the nine stocks cited, their forward ROEs and ROE growth rates are:
- Caterpillar: 45%, 33%
- Chas. Schwab: 21%, 38%
- Deere: 38%, 28%
- MetLife: 19%, 43%
- Microsoft: 39%, 13%
- Morgan Stanley: 13%, 34%
- Phillips 66: 15%, 34%
- Starbucks: 80%, 34%
- Varian: 26%, 18%
This analysis was presented in the March 23 edition of Goldman's U.S. Weekly Kickstart report, based on data through March 22. (For more, see also: 12 Growth Stocks That Will Win Long Term: Goldman.)
Drivers of Improved ROE
In 2017, the S&P 500 improved ROE by 180 basis points (bp), to 16.3%, and Goldman forecasts an additional improvement of 130 bp in 2018, to 17.6%. Of the 130 bp increase for 2018, about 70 bp comes from corporate tax rate reductions. They estimate that the average effective tax rate for the index will fall from 25% in the third quarter of 2017 to 21% in 2018. Consumer discretionary and telecom services companies will enjoy the biggest boosts to ROE from tax reform, respectively 246 bp and 225 bp, Goldman calculates.
Goldman notes that rising wages and commodity prices are leading to lower estimates of pre-tax profit margins. As a result, Goldman recommends that investors avoid companies with high labor costs relative to revenue. Consensus estimates indicate that consumer discretionary and health care stocks will suffer the most, they add.
On average, Goldman calculates that each 20 bp increase in the yield on the 10-Year U.S. Treasury Note produces a 10 bp decline in ROE for non-financial companies. Thus, they suggest that investors choose companies with low leverage. They indicate that their strong balance sheet basket of stocks outperformed its weak balance sheet counterpart by 760 bp during the past six months.
ROE vs. Price/Book Valuation
"Current sector valuations are tightly distributed around their consensus expected NTM ROE, with highly profitable sectors, such as Information Technology, carrying higher P/B [price to book ratio] valuations," Goldman writes. The biggest outlier in the direction of overvaluation, they find, is consumer discretionary. Its P/B ratio is 5.4, while history indicates that 4.6 is typical, given its forward ROE. As a result, Goldman recommends that clients be underweight in this sector.
The median stock in the ROE growth basket has a P/B ratio of 5.7 times, versus 3.5 times for the median S&P 500 stock covered by Goldman, and 3.3 times for the median S&P 500 stock overall. Despite the higher valuation, the median stock in the ROE growth basket delivered a total return of 2% year-to-date through March 22, versus a 2% decline on a total return basis for the median S&P 500 stock covered by Goldman.
Wider Market Implications
Measuring stock valuations on a price/book (P/B) basis, the current (as of March 22) ratio of 3.3 times for the full S&P 500 is in the 85th percentile of historical valuations for the past 40 years, Goldman writes. Moreover, when ROE is plotted against P/B ratios, the current trailing ROE of 16.3% historically suggests a P/B ratio of 2.8 times, they add. That, in turn, suggests that the S&P 500 should fall to 84% (2.8 / 3.3) of its March 22 value, or 2,221. The index closed March 29 at 2,640.87.
However, given a forward ROE of 17.6%, Goldman says that their year-end price target of 2,850 for the S&P 500 is only 5% above the level suggested by the historical correlation of ROE and P/B. This suggests that a value of 2,714 on the index would be expected given a 17.6% ROE. That, in turn, would represent a 2.8% gain from March 29.