It’s awful out there. But some observers believe that there are opportunities among the stock market wreckage, and you don’t need to embrace a lot of risk to find them.
David Kostin, a strategist at Goldman Sachs, identified 26 U.S. stocks in the S&P 500 that look well-positioned to get through a devastating economic downturn – yet, on average, these stocks are trading at valuations that are lower than they were at the depths of the financial crisis in 2009.
What makes this list particularly riveting is the fact that Mr. Kostin isn’t taking a naive view of the current situation. He noted that Goldman Sachs economists expect that U.S. gross domestic product will contract at an annualized rate of 24 per cent in the second quarter, which is by far the worst quarterly contraction on record since the U.S. Bureau of Economic Analysis began tracking growth in 1947.
Indeed, the worst contraction on record so far is the 10 per cent annualized dip in the first quarter of 1958, followed by the 8.4-per-cent contraction in the fourth quarter of 2008.
“Simply put, expected growth during the upcoming quarter will be 2.5 times worse than at any point during the past 73 years,” Mr. Kostin said in a note.
What’s more, he expects that the U.S. unemployment rate will spike to 9 per cent within a matter of months, up from a 50-year low of 3.5 per cent in February. He also expects that profit growth this year for companies in the S&P 500 will fall 33-per-cent below 2019 reported profits.
It sounds bleak. And with the S&P 500 down 34 per cent from its record high on Feb. 19, investors have a strong case for holding cash.
But Mr. Kostin identified stocks with three characteristics that he believes are essential to getting through this mess, which is a good start if you want to benefit from a recovery.
The first characteristic: Big, liquid market caps. The stocks that made his list have an average market capitalization of US$33-billion (based on the value of outstanding shares). That compares with a median average of US$16-billion for all stocks in the S&P 500.
The second characteristic: Strong balance sheets. He used five metrics here, corresponding with the Altman Z-score, a test for predicting the likelihood of bankruptcy. He looked at companies with strong working capital, retained earnings, sales and EBIT (earnings before interest and taxes) relative to assets; and strong market capitalization relative to liabilities.
“As liquidity in the credit markets falls, companies with the strongest balance sheets are in the best position to weather the negative cash flow resulting from the economic shutdown,” Mr. Kostin said in his note.
The third and last characteristic: Margin of safety, based on low valuations. To get a sense of valuations in all this uncertainty, he estimated that profits in 2021 (yes, next year) will be 10-per-cent below 2019 levels (in other words, there’s no V-shaped earnings recovery in the forecast here).
Using this approach, the stocks that made the list have price-to-earnings ratios that are, on average, 14-times estimated 2021 earnings. These same stocks traded at 18-times estimated earnings at the bottom of the bear market in 2009, which means that they are significantly cheaper today.
Here are the results, broken down by sector with the ticker symbols in parentheses. Consider this list as a starting point for potential ideas – and an indication that, even as stocks fall to new lows, some people are looking beyond the carnage.
- Health care: Alexion Pharmaceuticals Inc. (ALXN), Align Technology Inc. (ALGN), Gilead Sciences Inc. (GILD), Bristol-Myers Squibb Co. (BMY), Illumina Inc. (ILMN), Biogen Inc. (BIIB), Quest Diagnostics Inc. (DGX), McKesson Corp. (MCK).
- Information technology: Intel Corp. (INTC), Analog Devices Inc. (ADI), Texas Instruments Inc. (TXN), Qualcomm Inc. (QCOM), Maxim Integrated Products (MXIM), Salesforce.com Inc. (CRM), Xilinx Inc. (XLNX), Cognizant Technology Solutions Corp. (CTSH), Skyworks Solutions Inc. (SWKS).
- Communications services: Take-Two Interactive Software Inc. (TTWO), Electronic Arts Inc. (EA).
- Financials: T. Rowe Price Group Inc. (TROW).
- Consumer discretionary: Lowe’s Cos. Inc. (LOW), Best Buy Inc. (BBY), Walgreens Boots Alliance Inc. (WBA), Booking Holdings Inc. (BKNG).
- Consumer staples: Altria Group Inc. (MO)
- Industrials: United Parcel Service Inc. (UPS).
Full disclosure: The author owns shares in MO.