S&P 500 Return on Equity rose by 32 bp in third quarter to reach 15.7%, reaching its highest level in the last year, points out Goldman Sachs in a recent report.

Stuart Kaiser and the analyst team at Goldman Sachs in their recent report titled: ‘US thematic views’ point out companies continue to increase leverage to boost ROE.

S&P 500 ROE at 15.7%

According to the Goldman Sachs analysts, S&P 500 ROE stands at 15.7%, in the 58th percentile historically since 1975. During the third quarter, S&P 500 ROE rose by 32 bp, while the financials sector broke 10% and ex-financials climbed to 18.5%.

The following table highlights the sector ROEs:

Sector ROEs

The analysts point out that although the financials sector ROE remains weak, ranking in the 21st percentile historically, the sector was able to expand ROE by 28 bp this quarter and now stands at 10%. The Goldman Sachs analysts point out that higher EBIT margins balanced a large negative contribution to sector ROE from lower sales/asset turnover.

Delving deep into the financials, the analysts note four out of five DuPont components provided positive contributions to ROE, with the largest positive contribution from EBIT margins. They point out that margins for the sector have increased in three consecutive quarters since 2012 and now rank in the 62nd percentile historically. During the third quarter, EBIT margins rose by 69 bp to 22.1% and are now at their highest since 2008. The following graph highlights the financials’ EBIT margin hitting the highest level since 2008:

Financials EBIT Margin

The Goldman Sachs analysts note eight of ten S&P 500 sectors improved ROE in the third quarter, but only three sectors have higher ROE than 3Q 2012. Consumer staples posted the largest increase in ROE, the only sector to improve by more than 100 bp. However, industrials, info tech and telecom services all are more than 100 bp lower than last year.

Enhanced leverage – An easy way to protect ROE

The analysts anticipate challenged ROE and falling EBIT margins will prompt managements to continue to raise leverage. They point out that EBIT margins are high but weakening, thereby hindering ROE. Hence, the analysts suggest increasing leverage is the easiest path to protect ROE.

They suggest S&P 500 companies should take advantage of the opportunity to add leverage at historically low rates in a rising interest rate environment. They point out borrow cost remain in less than the 10th percentile historically for eight out of ten S&P 500 sectors.