Goldman Sachs: These 21 companies can endure higher borrowing costs and provide stability as the Fed’s battle against inflation continues to hurt bottom lines
- Fed Chair Jerome Powell may keep interest rates higher for longer, biting into company profits.
- Stocks across the market have seen lower returns on equity this year, according to Goldman Sachs.
- But 21 companies can handle the restrictive monetary policy and provide investors with stability.
The Federal Reserve’s higher-for-longer monetary policy has had a massive ripple effect in recent weeks, but the most significant impact will be on the bottom lines of companies across the market.
According to a recent note from Goldman Sachs chief US equity strategist David J. Kostin, stocks have enjoyed strong return on equity (ROE), a common measure of a company’s profitability and efficiency, over the last few decades.
“Since 1975, falling interest expense and greater leverage have contributed 18.5 pp of the overall 8.8 pp increase in S&P 500 ROE, while lower taxes have contributed 8.9 pp, higher EBIT margins contributed 5.9 pp, and lower asset turnover contributed -24.5 pp during the same period,” Kostin wrote in a note. “A recent Fed paper similarly found that lower interest expenses and corporate tax rates explain more than 40% of the real growth in corporate profits from 1989 to 2019.”
The Fed has now thrown a spanner in the works.
According to Kostin, higher interest rates and lower leverage are a double whammy for stocks. He noted that borrowing costs increased the most in nearly 20 years in 2023, which means that companies will have fewer reasons to borrow money to fuel their growth, weighing on profitability.
“If rates continue to rise or stay higher for longer, increased borrow costs would disincentivize companies to take on greater amounts of leverage,” he wrote in a note.
As a result, this year’s market ROE has been lower.
“S&P 500 ex-Financials trailing four-quarter return on equity (ROE) equals 23.4%, 69 bp lower than at year-end 2022 and 176 bp below its peak in 2Q 2022,” Kostin wrote in a note.
Kostin broke down the decline even further, noting that 31 basis points of the 69 basis point decline this year were directly attributable to higher interest expenses.
“Interest expense also dragged down ROE across every sector this year with Financials experiencing the largest drag (-159 bp) and Energy the smallest (-5 bp),” Kostin wrote in a note. “Reduced leverage, lower asset turnover, and a contraction in EBIT margins also weighed on S&P 500 ex-Financials ROE, contributing -42 bp total.”
He excludes financials from the equation because the majority of the ROE increase in that sector can be attributed to Berkshire Hathaway’s investment income, which skews the data.
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Higher interest rates will reduce profitability in the future, but the market has some bright spots.
According to Kostin, ROE increased in six of the S&P 500’s 11 sectors this year, with the consumer discretionary sector seeing the greatest increase and the energy sector suffering the most.
Although the energy sector’s ROE was significantly lower than the rest of the market this year, Kostin believes there may be opportunities ahead if oil prices continue to rise.
“If Brent oil prices rise to our commodities strategists’ 12-month target of $100, 19% above current 12-month ahead Brent futures prices, the sector would return +4% based on the relationship between the sector and oil prices,” Kostin wrote in an email.
Other future investment opportunities, according to Kostin, will be fewer and farther between due to higher-for-longer interest rates. Though he expects ROE across the market excluding financials to normalize next year, it is unlikely to rise as sharply as in the past.
However, due to the technology’s ability to improve efficiency and maximize profitability, artificial intelligence may play a role in higher ROE in the coming years.
“Although the ROE for S&P 500 companies sits in the 97th percentile vs. history, our analysis suggests an AI-driven increase in revenues and productivity could lift the trajectory of S&P 500 annual average EPS growth over the next 20 years by 50 bp to 5.4%,” Kostin wrote in a note.
But that is a long way off. Today, Kostin sees higher interest rates and deep-rooted inflation ahead, which may persist as a result of higher oil prices.
Fortunately, Kostin has assembled a portfolio of stocks that “are less vulnerable to rising rates and offer stability amid greater macro uncertainty,” he wrote.
The 21 stocks that meet the criteria are listed below. Each has low leverage, as measured by net debt to EBITDA; high interest coverage, with EBIT to interest expense in the top 25% of S&P 500 stocks; and EBITDA growth variability in the bottom 25% of the S&P 500 — in other words, “they have low vulnerability to higher borrowing costs,” according to Kostin.
Each stock includes its ticker, sector, market cap, year-to-date return, and most recent closing price, as well as its NTM P/E ratio, 3-month 2024 estimated EPS revision, net leverage, interest coverage, and 10-year EBITDA growth variability.
