The S&P 500 index has posted its highest return on equity (ROE) in nearly two decades and may have peaked along with the bull market. To address that, Goldman Sachs has screened a basket of 50 stocks that the firm says can still lead the market by posting the fastest ROE growth over the next year. "The basket has outperformed the S&P 500 by 5 pp YTD, consistent with other growth themes," says Goldman, adding “The median stock in the list is expected to see ROE improve from 16% to 19% during the next 12 months." The basket outperforms especially well when growth is scarce, the firm said.
8 Stocks With Superior ROE Growth
Source: Goldman Weekly Kickstart Report, March 15, 2019
While the median S&P 500 company is expected to post ROE growth of negative 4% during the next 12 months, some companies in Goldman’s sector-neutral basket are forecast to post growth near 50%. This group of winners includes TripAdvisor Inc. (TRIP), Chipotle Mexican Grill Inc. (CMG), Nike Inc. (NKE), Estee Lauder Companies (EL), Baker Hughes (BHGE), Cabot Oil & Gas (COG), Allstate Corp. (ALL), and Prudential Financial (PRU). (see table above).
Shares of Mexican food chain Chipotle, for example, are up 102% over 12 months and near 46% YTD, compared to the S&P 500’s 12.7% and 4.1% gains over the respective periods. In a recent note, Chipotle’s biggest bull, Piper Jaffray, set a price target at $725, citing opportunity in international markets as a key driver for future growth, per Barron’s. His forecast implies a near 12% upside from current levels.
Most of the stocks in the S&P 500 aren't likely to post those kinds of returns. One reason is that lower tax rates following Trump’s sweeping corporate tax cuts accounted for two-thirds of the index-level ROE improvement last year, per Goldman. Moving forward, analysts are skeptical that the market can sustain its ROE gains, recommending that investors focus on the impact of several key drivers of ROE. That includes margins, which analysts foresee staying flat through 2020, with risks tilted to the downside. As a result, the firm favors companies that are particularly equipped to withstand cost pressures in 2019. “Stocks with high and stable gross margins are likely to have more pricing power and the ability to pass through higher input costs and have outperformed this year (+17% vs. +9%),” wrote Goldman.
Secondly, Goldman recommends investors pay attention to potential downside from an expected rise in corporate tax rates this year, with Communications Services particularly vulnerable. Additional factors include high leverage and borrowing costs, per Goldman, noting that while investors punished companies for leverage and borrowing costs last year, they do not expect it will continue with a dovish Fed.
It’s important to note that Goldman says only 72% of the stocks in its high ROE basket are outperforming. This means that many investors might do well study each equity closely before buying.
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