Analysts at Goldman Sachs now have a slim 3% upside left to their S&P 500 target of 3,000 as of Tuesday close. In the investment bank’s U.S. Weekly Kickstart report dated April 12, Goldman recommends owning shares of 50 stocks with low operating leverage for the current environment. The group, which now trades at a 30% discount to its historical level, has outperformed the market this year and is poised to continue to do so amid a slowing U.S. economy, per the analysts. Investopedia looks at nine of them, including big brand stocks such as Walt Disney Co. (DIS), CBS Corp. (CBS), McDonald’s Corp. (MCD), Starbucks Corp. (SBUX), Hilton Worldwide Hldgs (HLT), General Dynamics (GD), Nvidia Corp. (NVDA) and HCA Healthcare Inc. (HCA).
(Degree of operating leverage)
- Walt Disney Co. (DIS); 1.8%
- CBS Corp. (CBS); 1.8%
- McDonald’s Corp. (MCD); 1.4%
- Starbucks Corp. (SBUX); 1.8%
- Hilton Worldwide Hldgs (HLT); 1.6%
- General Dynamics (GD); 1.7%
- Nvidia Corp. (NVDA); 1.9%
- HCA Healthcare Inc. (HCA); 1.4%
- S&P 500 (ex-Financials and Utilities) median; 1.6%
Source: Goldman Sachs U.S. Weekly Kickstart Report
Muted US Economic Growth Favors Low Operating Leverage Stocks
Goldman Sachs highlights the fact that economic growth has decelerated in the U.S., China and Europe. Meanwhile, the firm expects year-over-year (YOY) earnings growth for the average S&P 500 company to fall 3% in Q1, remain flat in the following two quarters and gain 9% in the final quarter of 2019.
“Stocks with low operating leverage outperform as the economy decelerates,” wrote Goldman analysts in the recent report. Alternatively, in periods of improving economic growth, stocks with high operating leverage win. “Although U.S. economic activity may have stopped decelerating (ignoring the government shutdown data), growth is likely to be muted. Modest growth means that firms with a low ratio of revenue after variable operating costs to revenue after variable and fixed costs should outperform stocks with a high degree of operating leverage,” read the report.
Equity Prices Inflated, Low Operating Leverage Stocks at a Discount
From a valuation perspective, Goldman views the S&P 500 index and the median stock as trading at high valuations relative to history, between the 80th and 98th percentile versus the past four decades. On the other hand, the group of low operating leverage stocks trades at a significant 30% discount in terms of price to earnings multiples compared to the previous decade, when the discount averaged a mere 3%. The basket trades at a forward P/E of 15x compared to 20x for stocks with a high degree of operating leverage.
“The sector-neutral low operating leverage basket has returned 17% YTD vs. 15% for both the S&P 500 and high operating leverage basket. Low operating leverage firms have slower sales and EPS growth but have higher margins (17% vs. 8%) and ROE (29% vs. 18%) compared with high operating leverage stocks,” wrote the Goldman analysts.
Walt Disney Co.
Entertainment industry giant Walt Disney has been receiving attention from the Street lately as it enters the on demand streaming space. The company is expected to launch its rival platform to competitors including Netflix Inc. (NFLX), Apple Inc. (AAPL) and Amazon.com Inc. (AMZN) in November of this year. At its investor day on Thursday, Disney said it expects its global subscriber number to hit between 60 million and 90 million by 2024. By comparison, Netflix boasts about 139 million subscribers. Disney is pricing its service at $6.99 per month, or $69.99 per year, compared to Netflix at $13 per month for a standard plan. Estimated spending for Disney stands at $2 billion in 2024, compared to the $12 billion Netflix spend on content last year, and showcasing the advantage of Disney’s trove of previously released titles.
Investors will be looking out for indicators of Disney’s financial plan for the coming years in its upcoming Q2 earnings call. Shares have gained 18.5% YTD, compared to the S&P 500’s 16% return over the period.
Goldman’s basket of low operating margin stocks is based on a forecast for decelerating economic growth. Investors with a different baseline outlook may consider another strategy. Additionally, while these low operating margin companies may outperform in the current environment, any cyclical or sector declines could weigh on shares of particular companies. Therefore, investors should pick and choose based on an array of factors including industry trends and other company fundamentals.