S&P 500 Underweight utilities

David J. Kostin and his team at Goldman Sachs recommend underweighting defensive names, particularly utilities. The sector has outperformed the S&P 500 (INDEXSP:.INX) as of February 28, 2014 bolstered by falling interest rates and positive earnings per share (EPS) revisions. Dividend yields of 4% are attractive to income-seeking investors compared to the 2% generated by the S&P 500. The colder than average winter has driven increasing EPS revisions and price gains in utilities.

Kostin believes that interest rates will resume their climb as economic growth improves this year. Goldman Sachs Group Inc (NYSE:GS)’ operating S&P 500 EPS target is $116 versus $118 consensus estimate. This provides for a target S&P 500 (INDEXSP:.INX) level of 1,900 versus the current 1,845 for a total return of about 3%. Goldman Sachs’ 2014 earnings growth estimate of 4% for utilities is below consensus estimates of 7%. Hence, Goldman Sachs is underweight utilities for 2014.

GS top down EPS VS Consensus bottom up

S&P 500 level and EPS buyback

Source: Happer, Lipper, Factset, CFTC, and Goldman Sachs Global Investment Research

utilities

Utilities versus S&P 500

Source: First Call, I/B/E/S, Factset, and Goldman Sachs Global Investment Research

S&P 500 Buybacks to dominate return of capital

Kostin’s team postulates that share buybacks will dominate capital return to shareholders this year. The strategy has returned 1% year to date as of February 28, in line with the S&P 500. Doing buybacks provides more flexibility to firms as buybacks can be done in stages with adjustable targets whereas dividend increases cannot be undone without sending a negative signal to the market. Financing buybacks is still cost effective given that large firms still have cash in their balance and can secure debt at low rates if needed.

buyback

Source: Factset and Goldman Sachs Global Investment Research

buybacks

Source: Factset and Goldman Sachs Global Investment Research

S&P 500 High operating leverage names to continue outperformance

Goldman Sachs Group Inc (NYSE:GS)’ high operating leverage basket has returned 4% year to date as of February month end outperforming the S&P 500 (INDEXSP:.INX). Companies with high operating leverage tend to have larger fixed costs relative to variable costs. As the volume and size of sales increase, the sale contributes more to the bottom line. If economic growth improves this year as Kostin expects, firms with high operating leverage get higher EPS growth driven by revenues which in turn drives higher stock price appreciation relative to competitors.

High operating leverage

Source: Factset and Goldman Sachs Global Investment Research