Companies with weak balance sheets have outperformed those with strong balance sheets by 49 percentage points over the last two years, gaining 89% versus 40%, according to a recent Goldman Sachs report, and there appears to be more room for outperformance as the combination of a bull run and cheap credit will likely continue the trend.
Weak balance sheets are strongest thematic basket: Goldman Sachs
“Our weak balance sheet portfolio deserves attention given the 7% YTD absolute return – tops among our thematic baskets – and 600 bp of steady outperformance versus a basket of strong balance sheet stocks,” write Goldman Sachs analysts David J. Kostin, Stuart Kaiser, Amanda Sneider, Ben Snider. “We believe weak balance sheet firms will continue to lead based on history.”
Having a strong balance sheet was an asset during the financial crisis, as earnings contract, financing dried up and it became increasingly difficult to rollover debt, which the Goldman Sachs report says is typical. Weak balance sheets normally outperform when GDP growth is +2%, EPS is strong, and credit is loose, and underperform during a contraction (negative GDP growth, flat or falling EPS, tight monetary conditions). Since they expect economic conditions to reflect the first situation more than the second for at least the next two years, they expect the weak balance sheet basket to continue outperforming.
“Historical precedent that suggests we may be only half way through the current cycle,” they write.
Tech stocks account for half of weak balance sheet outperformance
Even with the recent correction, tech stocks have accounted for about half of the recent outperformance from weak balance sheet stocks, which gives a clue as to why the trend that Goldman Sachs identifies exists in the first place. When there is plenty of liquidity and sentiment is bullish, companies that don’t have much inherent value but tell a great story can reach sky-high valuations. A contraction forces investors to reconsider their positions (and scares many retail investors out of the market) causing those stocks to fall. It’s no secret that purely speculative stock prices can rise higher and fall faster than value stocks.
Put another way, Goldman Sachs research suggests that we are another year or two away from a market top, and that there is still room for investors to make money, as long as you’re not the last one out the door.