High quality stocks have lagged their lower-quality peers so far this year. History suggests that investors will start to choose quality as financial conditions tighten. Goldman Sachs shared 50 quality stocks that appear to have room to rise. In theory, this year’s ugly market environment should have caused investors to flee to the safety of high-quality stocks. But that hasn’t quite been the case, according to Goldman Sachs.
Quality companies with high returns on capital trade at an earnings multiple of 18x, which is just a 5% premium to stocks with low returns on capital, wrote David Kostin, the firm’s chief US equity strategist, in a mid-September note. While that rate is higher than the 2% median premium in the past 35 years, it’s well below the 10% premium of the past decade, he noted.
“Firms with high returns on capital carry a valuation premium close to historical averages despite elevated current pressures on corporate profitability,” Kostin wrote in the note.
That disconnect may present an opportunity at a time when sound investments are hard to come by. Higher interest rates in response to high inflation have hurt both stock valuations and fundamentals, which makes quality stocks all the more attractive, in Kostin’s view.
“Pressure on profitability and tightening financial conditions support owning stocks with high returns on capital, which trade at a lower valuation premium than other ‘quality’ factors such as strong balance sheets and low volatility,” Kostin wrote.
Stocks with strong balance sheets, low volatility, and high returns on capital outperform. Goldman Sachs Historically, quality stocks have been a strong bet when financial conditions tighten. Since 1990 firms with high returns on capital have outperformed lower-quality counterparts by 9%, while companies with strong balance sheets and those with low volatility have each topped lesser peers in those aspects by 8%, according to Goldman Sachs.
But this year has been an anomaly. Stocks with high returns on capital have lagged those with low returns on capital by 9% in 2022, Kostin noted.
50 cheap quality stocks to buyWhile quality stocks haven’t performed as expected in 2022, Goldman Sachs thinks the cream — as in stocks with better returns on equity than their sector peers — should rise to the top.
Below are 50 such names that Goldman Sachs highlighted, along with each stock’s ticker, sector, return on invested capital (ROIC), return on assets (ROA), and return on equity (ROE). The “NM” under some stock’s ROIC or ROE means “not meaningful.”