Investors use the Sharpe ratio to see if they’re being rewarded for the risks they take. David Kostin at Goldman Sachs is applying a version of that concept to individual stocks. He says that approach has historically delivered excess returns without much extra risk. Investing always involves some sort of risk, so the question of what reward an investor is getting for the risks they take is an important one.
That’s essentially what the Sharpe ratio is for. Developed by economist William Sharpe in the 1960s, it’s intended to show the long-term difference between the performance of a portfolio and a benchmark or nearly zero-risk investment (US Treasury bonds are considered the least-risky investment imaginable).
Goldman Sachs Chief US Equity Strategist David Kostin says that zeroing in on stocks with higher Sharpe ratios has been a successful strategy over time, delivering better returns than the S&P 500 and the vast majority of core stock funds for decades.
“Since 1999, a sector-neutral, equal-weighted, portfolio of 50 S&P 500 stocks with the highest prospective risk-adjusted returns has posted a 65% semi-annual hit rate of outperformance vs. the broad index with an average excess return of 260 bp (520 bp annualized),” he wrote in a recent note to clients.
But now Kostin is using the concept of Sharpe ratios in a unique way. Instead of evaluating the performance of a mutual fund or a portfolio, he’s interested in finding stocks that are going to deliver solid returns going forward.
“We define a stock’s prospective Sharpe ratio as the return to the consensus 12-month price target divided by the 6-month option-implied volatility,” he said. That is, Kostin wants to find stocks that have a lot of upside to Wall Street’s targets, but that aren’t expected to be especially volatile.
“The median stock in our basket is expected to generate more than two times the return of the median S&P 500 stock (36% vs. 14%) with only slightly higher implied volatility (36 vs. 31),” he said. Goldman has long maintained a basket of high Sharpe ratio stocks, and he says that the stocks haven’t been this cheap in two years.
The following stocks comprise Goldman’s high Sharpe ratio basket. They’re the companies that have the highest upside (based on consensus price targets) relative to the expected volatility priced in their options over the next six months. The higher the ratio, according to Kostin, the greater the reward relative to the risk of volatility. Ratios were calculated as of December 19.