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High Quality Stocks Start To Outperform Junk: Goldman Sachs

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According to Goldman Sachs, just like cream floats to the top of fresh milk, “high quality” stocks with low volatility, high returns on capital, strong balance sheets and high dividend yield will come out on top of lower quality stocks in 2015 – a trend which started in late 2014.

In their January 16th US Weekly Kickstart, GS analysts David J. Kostin and team say that quality stocks with the profile described above “have maintained strength in the first weeks of 2015. Historical performance during decelerating earnings growth cycles suggests these factors should continue to outperform, and we highlight 23 stocks that share these key characteristics.”

Value outperformed growth in 2014

The Goldman report noted that value outperformed growth once again in 2014, but only moderately. Kostin et al point out that their sector-neutral, long/short valuation factor returned +1% in 2014 relative to -1% for growth. Of note, value has been one of the most consistent and best-performing historical factors, yielding an annualized average return of 9% since 1980 and positive returns in most macro environments. Value produced a 16% return in 2013 as the S&P 500 P/E soared by almost 30%. The GS growth factor has only produced a -1% average historical return.

Goldman Sachs on oil prices

The GS commodity team revised its forecast for crude oil down again this week. The new projection is for Brent to average $50 a barrel in 2015, bottoming around $40 in the second quarter before climbing to $70 by year-end. The analysts also reiterate their earlier call that low oil is good for the U.S. economy overall. “Despite investor concerns, we estimate that lower oil prices should be a net positive for US economic growth and S&P 500 EPS.”

High quality stocks will continue to outperform

The main thesis of this installment of the US Weekly Kickstart is that although S&P 500 firms with high returns, low volatility, and strong balance sheets underperformed their “low quality” counterparts by more than 20 pp from mid-2012 through mid-2014 as financial conditions loosened and US growth accelerated, “high quality” stocks have been rebounding strongly since the third quarter of last year. Kostin and team note: “This trend turned at the same time as risk sentiment, and these types of “high quality” stocks have rallied in unison since (Exhibit 2).”

High Quality Stocks

The GS analysts also argue that slowing earnings growth this year augurs that low volatility, high momentum, and high dividend yield stocks should continue to outperform over the next few quarters.

Also of note, S&P 500 EPS growth cycles are historically the reliable indicators of factor performance. Given current high margins and global growth slowing, GS projects EPS growth will decelerate from 9% in 2014 to just 5% in 2015.

High Quality Stocks

Kostin et al highlight the strong performance of high quality stocks when earnings slow down. “In six decelerating earnings cycles since 1980, low volatility stocks have outperformed their high volatility peers in each episode, posting a median annualized return of 5%. Momentum and dividend yield stocks have also performed well.”

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