Investors in U.S. stocks need to focus on balance-sheet strength and beware record-high net leverage, according to a report from Goldman Sachs Group Inc.
Stocks with weak balance sheets have outperformed those with strong ones since 2009, an “unusual” pattern as companies took advantage of the low cost of borrowing, Goldman wrote. But strong balance sheets have taken the lead since 2017 as rates march higher.
“Corporate managers should continue to deleverage,” the Oct. 4 report from strategists led by Cole Hunter and David Kostin said. “Prudent investors have already started to reward stocks with strong balance sheets given near record net leverage, rising interest rates, and the belief by many investors that a recession will occur in 2020.”
Returning cash to shareholders is a “winning long-term strategy” for boosting stock prices that fares best when growth in gross domestic product is strong like it is this year, the report said. Goldman expects companies that prioritize buybacks and dividends will continue to outperform firms investing for growth next year.
Members of the S&P 500 Index will boost total cash spending by 13 percent to $3 trillion in 2019, the report said, with cash spent on mergers and acquisitions climbing 16 percent to $400 billion and buybacks increasing 22 percent to $940 billion after a gain of 44 percent this year.Higher stock valuations do present a risk on the share-repurchase front, the report said. The median S&P 500 stock ranks in the 97th percentile of historical valuation using metrics like price-to-earnings ratios and price-to-book ratios, so the accretive effect of repurchasing shares is smaller than at other times, it noted.
Goldman boosted its estimate of buyback growth this year to 44 percent from an original 23 percent, noting that tax reform has provided extra incentive for company repurchases. It also raised 2018 estimates of capital expenditures and research and development.
In addition, the backdrop for an increase in cash M&A spending is constructive, the report said. The Conference Board’s survey of chief executives’ economic expectations is off recent highs, and historically there’s a negative relationship between confidence and cash deals because when executives are confident they tend to invest organically as opposed to pursuing M&A.
“Announced M&A with U.S.-based acquirers increased by more than 50 percent year-over-year to $1.3 trillion,” the strategists wrote.“The surge in announced deals this year suggests a more optimistic outlook for completed deals in 2019.”