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- Companies singled out by Goldman Sachs as having strong balance sheets continue to outperform those with weaker cash positions this year.
- But many of the strong companies are also growth stocks, putting them at risk of faltering if investors turn more defensive.
- Companies with strong balance sheets historically don't overlap with those that have high earnings growth, Goldman's David Kostin said.
- Kostin still recommends the firm's strong-balance-sheet basket.
Companies with plenty of cash and not as much debt are crushing it.
Goldman Sachs' basket of stocks with strong balance sheets has outperformed its selection of cash-strapped companies by 8% this year, the bank's equity strategists said in a note on Friday. That's also a better performance than the S&P 500, which has gained 4.02% this year.
The firm again recommended buying its basket of strong-balance-sheet stocks, but highlighted a risk that could work against them.
Many of the companies with the strongest balance sheets also have the strongest earnings growth. They include include big names like Facebook and Alphabet that led the market higher last year, as momentum-driven investors looked to profit from their upward trend.
"The overlap between growth stocks and strong balance sheets represents a risk to the balance sheet trade going forward," David Kostin, the chief US equity strategist, said. "We believe growth stocks remain an attractive investment opportunity. However a rotation away from momentum and growth stocks could also weigh on strong balance sheet stocks despite the strong macroeconomic argument for their outperformance."
In theory, such a rotation should not hurt companies with strong balance sheets since they'd have more firepower to continue paying interest on their debt than those with less cash. That would be crucial if the rotation is followed by an economic downturn and weaker profits.
However, this overlap between companies with strong balance sheets and high-growth stocks is historically unusual, Kostin said. And it means a shift in investor sentiment could be negative for the basket.
His base case is that the US economy will remain healthy and the Federal Reserve will continue raising interest rates. Because higher rates tighten lending conditions, it pays to stick with companies that have the least trouble financing their debt.
"The best outcome for weak-balance-sheet stocks would be an environment of healthy economic growth but a dovish Fed, which appears unlikely," Kostin said. Traders see a 100% probability that the Fed will raise interest rates at its meeting this week, according to Bloomberg.