Twenty-three high-quality stocks Goldman thinks are set to outperform

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Buying quality stocks sounds like a no-brainer. Who wouldn't want quality? Plenty of investors, it seems.

According to Goldman Sachs, stocks with strong balance sheets, low volatility, low valuations and attractive dividend yields have lagged so-called low-quality stocks throughout most of the past two years by an astounding 20 percentage points. Investors have preferred low-quality stocks as a better way to position themselves for an improving economy and looser monetary conditions.

But things are changing. Equity markets have turned volatile, the U.S. dollar has rallied, inflation expectations have nosedived and investors have turned more risk-averse as earnings growth subsides.

The CBOE volatility index – or VIX, a fear gauge that rises with investor anxiety – has spiked above 20 from lows below 12 last summer.

China's economy expanded by 7.4 per cent in 2014, for its slowest annual growth since 1990 and below the official target of 7.5-per-cent growth. That underscores concerns that a key growth engine for the world is sputtering.

The International Monetary Fund has cut its global growth projection for 2015 to 3.5 per cent, down from 3.8 per cent – as crumbling crude oil and copper prices signal potential trouble ahead.

Investors have been seeking havens, driving gold higher and the yield on the 10-year U.S. Treasury bond lower to just 1.79 per cent – down from nearly 2.2 per cent at the end of 2014.

Given these shifts, has the time arrived for quality stocks? Goldman Sachs strategist David Kostin thinks so.

"With margins hovering at peak levels and global growth slowing, we expect [earnings per share] growth will decelerate from 9 per cent in 2014 to 5 per cent in 2015," he said in a recent note.

"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 per cent. Momentum and dividend yield stocks have also performed well."

Mr. Kostin has assembled a list of 23 stocks that meet his high-quality criteria for volatility, valuation, yield and momentum.

Together, the stocks on his list have an average dividend yield of 2.6 per cent, above the 2.1-per-cent yield for the S&P 500. They are also cheaper, trading at 15.5 times estimated earnings (the S&P 500 trades at 16.3 times earnings).

However, earnings are expected to grow just 3 per cent in 2015, based on the median average, and sales growth is expected to be flat – suggesting that high-quality stocks aren't exactly dynamos in regards to growth.

That's largely why quality stocks have been ignored by many investors looking for ways to cash in on a humming global economy. Now that the economy is sending some worrisome signals, though, the era of quality could be arriving.

'High-quality' stocks

These are stocks that fill Goldman strategist David Kostin's criteria for volatility, valuation, yield and momentum. Note that several U.S. energy producers made the list.

• Lorillard Inc.
• Aetna Inc.
• Pepco Holdings Inc.
• Entergy Corp.
• Kimberly-Clark Corp.
• Safeway Inc.
• Intel Corp.
• Target Corp.
• International Paper Co.
• L-3 Communications
• Holdings
• Cisco Systems Inc.
• Raytheon Co.
• Symantec Corp.
• Time Warner Inc.
• ACE Ltd.
• Stanley Black & Decker Inc.
• Family Dollar Stores Inc.
• Wells Fargo & Co.
• Chevron Corp.
• Valero Energy Corp.
• ConocoPhillips
• National Oilwell Varco
• Marathon Petroleum Corp.

Source: Goldman SachsSource: Goldman Sachs