Companies with weak balance sheets continue to be the most popular with investors, continuing a streak that began at the end of 2012 and has made it the best performing of Goldman Sacs strategy baskets, gaining 16% through July 18, nearly double the S&P 500’s growth over the same period. High Sharpe Ratio stocks were next best with 12% gains, followed by High Hedge Fund Concentration (11%). The worst performing strategy baskets so far this year are High Revenue Growth, High Quality Stock, and Low Hedge Fund Concentration, all of which returned 6%.

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Weak balance sheets a liability if rates go up next year

“Our Weak Balance Sheet basket identifies 50 S&P 500 companies across eight sectors with weak balance sheets. We use the Altman Z-score to measure balance sheet strength,” write Goldman Sachs analysts David J. Kostin, Amanda Sneider, and Ben Snider, “As the credit environment tightened, these companies were less likely to have access to funds necessary to invest in growth.”

The Altman Z-score is just a weighted sum of five ratios: working capital/total assets; retained earnings/total assets; EBIT/total assets; market cap/total liabilities; and sales/total assets. Normally a low Z-score is meant to indicate that a company is in danger of going bankrupt in the next couple of years, so tightening credit and rising rates should pose a danger to these stocks, but the market hasn’t seemed to mind.

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High Sharpe Ratio stocks outperform the market with similar implied volatility

The original Sharpe Ratio was supposed to measure how skillfully someone has picked stocks in the past by taking the ratio of outperformance (relative to the risk-free rate) and volatility. To make this a forward looking screen Goldman Sachs uses consensus price targets as a proxy for expected returns and implied volatility from 6-month options to put together its High Sharpe Ratio basket, also of 50 S&P 500 stocks, weighted to give the basket the same sector composition as the S&P 500 (INDEXSP:.INX).

While this basket has had a bumpier ride, it’s also been outperforming fairly consistently since 2012, and Kostin, Sneider, and Snider say that the median stock in the High Sharpe Ratio basket still has more than twice the expected return of the S&P 500 (15% to 7%) with the same 20% implied six-month volatility as the broader index.

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