How To Find Winning Stocks, According To Goldman Sachs

If you’re hunting for a savvy stock play, Goldman Sachs says you’re going to want to look beyond the trusty old index ETFs that’ve served you well in the past. The investment bank says the US economy will probably avoid a recession this year, but stock markets will probably just fumble along – and investors who want to do well will have to look for “alpha” (not “beta”) opportunities. So, here’s Goldman’s outlook and where to find those opportunities…

What’s the economy going to do?

Despite all the doom and gloom, growth remains resilient. In the US, the closely watched Institute for Supply Management (ISM) manufacturing index recently came in better than expected with production, new orders, and employment components increasing – all signs of a growing economy. Data has also been particularly strong in Europe and the UK, and China is growing above the trend. There remains a risk of a US slowdown in the second half of the year, as the regional bank crisis and interest rate hikes continue to bite, but Goldman Sachs says the US will avoid a full-blown recession.

Company earnings and profit margins have also fared better than expected in the latest quarter. In the US and Europe, earnings-per-share (EPS) has been stronger than usual, on average outpacing expectations by 7% (which is more than the typical beat). In the US, companies have been able to raise their prices even more than the rate of inflation, protecting their margins.

Corporate margins have been resilient to rising input costs. Source: Goldman Sachs and Datastream.

That’s good news for the share prices of the companies that have successfully hiked prices, but bad news for household finances, which continue to get squeezed.

So shouldn’t stocks be doing well, then?

Not exactly, and certainly not all of them. Stock valuations look expensive today, relative to their history, across all markets, but they are especially so in the US.

Equity market 12-month forward price-to-earnings (P/E) valuations. Source: Goldman Sachs.

At an 18.8x price-to-earnings (P/E) ratio, US stocks are trading above their 20-year median (the gray square in the graph above). One key risk is that if there is a recession – or if the market starts to price in the risk of a recession – the S&P 500 could decline 20% from current levels.

And while other international markets look cheaper than the US, they are also trading close to their historic fair value, so Goldman says any significant upside needs to be caused by lower interest rates – which is just not likely in the current environment. Still, with higher interest rates, cash and money market funds are a realistic, relatively risk-free alternative.

OK, so where can you look for opportunities?

In this new world of higher interest rates, it’s not enough to go after the “beta” – essentially, buying exposure to the whole market with a low-fees index fund. Instead, says Goldman, you’ll want to hunt for the “alpha”, the stocks and sectors that’ll contribute the most to the index’s returns.

To find alpha, Goldman says paying close attention to valuations and diversification – across regions, sectors, and themes – will be hugely important. It’s recommending an overweight position in non-US markets that look cheap and that have a similar growth profile to the US like Europe. For US investors, the bank says, the current weakness in the US dollar will mean even better returns down the line.

And looking across markets, Goldman has identified three attractive areas of interest: quality growth, stable margins, and particularly cheap value stocks – what the investment bank refers to as “deep value” stocks.

What are the deep-value opportunities?

Energy ranks prominently among deep-value stocks. Although the price of oil has been weak recently as concerns about an economic slowdown grow, energy stocks favored by Warren Buffett like Occidental and Chevron trade at an 11x P/E ratio, a significant discount to the overall market’s 19x P/E ratio. If you prefer ETFs, the SPDR Energy Select Sector (ticker XLE; expense ratio: 0.1%) provides exposure to all the large-cap energy stocks.

Industrial metals make the cut as well. Goldman remains optimistic about the outlook for industrial metals, due to the expected pickup in demand from the green energy transition.

Metals demand could give US metals and mining stocks some lift. Source: Goldman Sachs

US mining stocks are trading at an average 15x P/E. And you could consider the SPDR Metals & Mining ETF (XME; 0.35%) if you agree that green energy demand will drive metals prices higher. Just be aware that it might not give you a smooth ride higher: recent worries about an economic downturn have pressured metals prices (as well as oil) lately and that’s being felt by the ETF.

European banks are also a deep value play. Unlike US banks, European banks face a strict regulatory regime with high capital requirements and that gives them a fair amount of stability. It’s why, aside from Credit Suisse, European banks have long looked well-positioned. The iShares STOXX Europe Banks UCITS ETF (SX7E; 0.46%) provides exposure to those big money houses. At a 7x P/E and an indicated 7% dividend yield, they are definitely cheap, trading at a significant discount to Europe’s 13x P/E average. Interestingly, the top ten European stock picks by artificial intelligence (AI) fintech company Danelfin – based on hundreds of technical and fundamental factors – are all banks.

What about quality growth and stable margins?

Goldman looks to consumer staples in the US and healthcare in Europe, both of which should be more resilient in the face of tighter financial conditions. The Consumer Staples Select Sector SPDR (XLP US; 0.1%) holds companies like Procter & Gamble, PepsiCo, and Coca-Cola, which all showed in their recent results that they can pass along price increases to their customers to protect their margins.

The MSCI Europe ETF (IEUR; 0.09%), meanwhile, may be one of the most sensible ways to add some European diversity to your portfolio. See, its top ten holdings (accounting for around 20% of its asset mix) are mostly stocks that Goldman expects to outperform in Europe. These are the so-called “GRANOLA” stocks – GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L'Oréal, LVMH, AstraZeneca, SAP, and Sanofi – stocks with strong earnings, defensive characteristics, high and stable margins, and strong balance sheets, as well as compounders with sustainable dividends.

Add in some oil shares and banking shares, which also have a reasonable-sized weighting in the MSCI Europe ETF, and you get a combination of deep value, quality growth, stable margins, and international exposure all in one place.