9 High-Return Stocks Poised to Thrive in Volatile Markets: Insights from Goldman Sachs

The S&P 500 Index (SPX) is projected to deliver strong return on equity (ROE) growth this year, largely driven by corporate tax cuts that help offset rising expenses, according to Goldman Sachs Group Inc. (GS). Goldman has identified nine standout stocks expected to experience the fastest ROE expansion: 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).

Spotting the Fastest ROE Growers

Goldman Sachs' ROE growth basket includes 50 stocks, representing all 11 sectors of the S&P 500. These selections are forecasted to achieve the most rapid ROE gains over the next 12 months. Some, including MetLife, Caterpillar, and Deere, were also featured in Goldman's January "Conviction List" of top picks. (For further reading, see: 10 Stocks That Can Outperform in 2018: Goldman.)

The median stock in this basket has a forward-looking ROE of 28% and an anticipated ROE growth rate of 23%. In comparison, the median S&P 500 stock covered by Goldman analysts shows a 20% forward ROE and a slight 1% decline in ROE.

Taking Starbucks as an example, its trailing twelve months (LTM) ROE was 60%, with a forecasted increase to 80% based on forward earnings, reflecting a 34% growth ((80% / 60%) - 1).

For the nine highlighted stocks, their forward ROEs and growth rates are as follows:

• Caterpillar: 45%, 33%
• Charles Schwab: 21%, 38%
• Deere: 38%, 28%
• MetLife: 19%, 43%
• Microsoft: 39%, 13%
• Morgan Stanley: 13%, 34%
• Phillips 66: 15%, 34%
• Starbucks: 80%, 34%
• Varian Medical Systems: 26%, 18%

This analysis was featured in the March 23 edition of Goldman's U.S. Weekly Kickstart report, using data up to March 22. (See also: 12 Growth Stocks That Will Win Long Term: Goldman.)

Factors Driving ROE Improvement

In 2017, the S&P 500's ROE improved by 180 basis points to 16.3%, with Goldman forecasting an additional 130 basis point increase in 2018, reaching 17.6%. Approximately 70 basis points of this growth are attributed to reductions in the corporate tax rate. Goldman estimates the average effective tax rate for the index will drop from 25% in Q3 2017 to 21% in 2018. Consumer discretionary and telecom services sectors are expected to benefit the most from tax reforms, with ROE boosts of 246 and 225 basis points respectively.

However, rising wages and commodity costs are pressuring pre-tax profit margins, leading Goldman to advise investors to steer clear of companies with high labor costs relative to revenue. Consumer discretionary and healthcare stocks are anticipated to face the greatest margin challenges.

Goldman also notes that every 20 basis point increase in the 10-Year U.S. Treasury yield typically results in a 10 basis point drop in ROE for non-financial firms. Consequently, they recommend focusing on companies with low leverage. Their basket of stocks with strong balance sheets outperformed those with weaker finances by 760 basis points over the past six months.

ROE Versus Price-to-Book Valuation

"Current sector valuations closely align with consensus expected forward ROE, with high-profit sectors like Information Technology commanding higher price-to-book (P/B) ratios," Goldman explains. The consumer discretionary sector stands out as an overvalued exception, with a P/B ratio of 5.4 compared to its historical norm of 4.6 given its forward ROE. As a result, Goldman recommends underweighting this sector.

The median stock in the ROE growth basket carries a P/B ratio of 5.7, compared to 3.5 for the median S&P 500 stock covered by Goldman and 3.3 for the overall S&P 500 median. Despite the higher valuation, the ROE growth basket delivered a 2% total return year-to-date through March 22, while the median S&P 500 stock covered by Goldman declined by 2% in total return terms.

Broader Market Insights

On a price-to-book basis, the S&P 500’s current ratio of 3.3 (as of March 22) ranks in the 85th percentile of valuations over the past 40 years, Goldman notes. When plotting trailing ROE of 16.3% against P/B ratios, the historical relationship suggests a fair P/B of 2.8. This implies the S&P 500 should trade at about 84% of its March 22 value, or roughly 2,221. The index closed at 2,640.87 on March 29.

However, with a forward ROE forecast of 17.6%, Goldman’s year-end price target for the S&P 500 is 2,850, only 5% above the level implied by historical ROE and P/B correlations. This suggests an expected index level near 2,714, representing a modest 2.8% gain from March 29.

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