The gap between expensive and cheap stocks is the widest since the tech bubble - and Goldman Sachs has created the perfect trade to avoid getting trapped on either side
- The valuation gap between stocks with rapid earnings growth and those undervalued relative to fundamentals is at its widest since the tech bubble, according to Goldman Sachs research.
- The firm's equity strategists have formulated a strategy with specific stock picks to avoid the risks that lie in either extreme.
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One of the highlights of 2019 for value investors will be the period when they unexpectedly stole the spotlight.
As recession concerns began to wane in September, so-called value stocks that are considered cheap relative to fundamentals suddenly overtook high-flying growth stocks. The rotation was so outsized that a Morgan Stanley strategy which bets on the best-performing stocks and wagers against the worst performers suffered its worst single-day decline on September 9, according to Bloomberg data.
It was a notable feat considering that value has lagged behind for much of the 10-year bull market. Investors have instead placed a premium on large companies that that grew earnings faster than their peers. This cohort also tends to be synonymous with momentum stocks that experience the most rapid gains.
Value stocks have lagged so far behind growth that the gap between high-multiple and low-multiple stocks is the widest since the tech bubble, Goldman Sachs research shows.
Naturally, investors are questioning whether the value comeback was more than just a blip.
The first part of Goldman's answer is that the existing gulf should not be used as a timing tool. In other words, value stocks are not more attractive because they are extremely cheap, and growth stocks are not undesirable because of their high multiples.
How then can investors take advantage of the valuation gap and avoid getting burned on either side? David Kostin, Goldman's chief US equity strategist, says the answer is to buy stocks with Growth at a Reasonable Price.
GARP stocks were popularized by legendary Fidelity investor Peter Lynch and are more or less what they sound like in full: companies that grow faster than their peers but are also undervalued relative to their peers. You can think of them as the best of both worlds.
According to Kostin, this Goldilocks category is ideal now because the hypothetical conditions needed to drive value's outperformance simply aren't present. He narrowed these conditions down to two scenarios: a strong or improving economy that would encourage risk-taking in cheaply valued stocks, and a weak economy that would benefit underowned stocks relative to their more expensive peers.
"During periods of modest economic growth - such as our forecast for 2020 - investors pay a valuation premium for stocks that can generate idiosyncratic growth," Kostin said in a recent note to clients.
"Accordingly, we recommend investors focus on stocks with Growth at a Reasonable Price (GARP), strong growth but without the extreme valuations carried by many secular growth stocks."
Kostin went further to detail what goes into Goldman Sachs' GARP basket.
It starts with a screen of Russell 1000 members that rank in the top 20% of sector growth based on an average of trailing and forward sales, earnings-per-share, and long-term expected growth. It excludes firms that are forecast to have declining revenues in 2020 and those in the top quintile of earnings-growth volatility over the past 10 years.
It then excludes the growth and value outliers in each sector: stocks in the top and bottom 20% of valuations based on metrics including the price-to-earnings and price-to-book ratios. The final product is a list of stocks that have "reasonable valuations" and yet promise strong secular growth.
Listed below are the top constituents in each sector except materials, which is absent from the basket:
- Communication Services: Alphabet
- Information Technology: EPAM Systems
- Consumer Discretionary: MGM Resorts
- Consumer Staples: Estee Lauder
- Energy: National Oilwell Varco
- Financials: Willis Towers Watson
- Health Care: Teleflex
- Industrials: L3Harris Technologies
- Real Estate: CBRE Group
- Utilities: Sempra Energy