(Sign up to receive EcoPulse stories: SALT ECOPULSE)
Feb. 7 (Bloomberg) -- Shares of companies with high operating or financial leverage are outperforming the market, as investor sentiment about the economy improves.
Two portfolio indexes of such stocks maintained by Goldman Sachs Group Inc. have outpaced the Standard & Poor’s 500 Index since October, a sign that riskier investment strategies are gaining favor. As the expansion strengthens, companies with higher fixed cost structures or weaker balance sheets are “more likely to benefit from that recovery,” said Tim Ghriskey, who oversees about $2 billion as chief investment officer of Solaris Group LLC, based in Bedford Hills, New York.
Goldman Sachs’ Weak Balance Sheet Basket -- comprising 51 companies including hospital operator Tenet Healthcare Corp. and truck lessor Ryder System Inc. -- has outpaced the S&P 500 by 8.8 percentage points since Oct. 1. The bank’s High Operating Leverage Basket -- made up of subscription-video service Netflix Inc., technology consultant Computer Sciences Corp. and 50 other members -- is almost 14 percentage points ahead.
A rise to new relative highs would be a confirming signal for investors looking to see if the recent jump in the S&P 500 is durable, Ghriskey said. The benchmark index closed at 1,466.47 on Jan. 4, the highest since Dec. 31, 2007, and has climbed 3.1 percent since then.
Gains in the Goldman Sachs baskets since the fourth quarter of 2012 “match what we’re seeing in the economy, which has been a resumption of slow, steady improvements,” he added.
While U.S. gross domestic product unexpectedly contracted at a 0.1 percent annual rate in the three months ended Dec. 31, rising auto sales led a 2.2 percent advance in consumer spending, which accounts for about 70 percent of the economy. A jump in pay may have helped. After-tax income rose 6.8 percent from October through December, the most in four years.
Housing and employment also are strengthening. The S&P/Case-Shiller index of property values in 20 U.S. cities increased 5.5 percent in the year through November, the largest gain since August 2006. And U.S. employers added 157,000 workers in January, following a revised 196,000 advance the prior month, based on data from the Labor Department.
The relative outperformance of risky equities “shows that the market’s rally has broadened recently,” according to Jim Stellakis, founder and director of research at Greenwich, Connecticut-based research company Technical Alpha Inc. and a chartered market technician. “Investors are more comfortable having their money parked in these types of stocks now.”
Goldman Sachs’ weak balance-sheet basket -- which excludes financials and utilities -- measures financial strength among S&P 500 companies using metrics such as levels of debt relative to total capitalization, based on information from the New York bank. These businesses benefit from economic growth because increased revenue allows them to pay down their obligations more easily, Ghriskey said.
The basket with high operating leverage also excludes financials and utilities. A larger portion of the costs for these S&P 500 companies is fixed compared with their sector peers, so an improvement in sales causes a disproportionate boost to profits, he said.
Companies in the latter group are “positioned to do well in this environment” because they have greater earnings sensitivity to an improving economy, said Eric Teal, chief investment officer at First Citizens BancShares Inc., which manages $4.5 billion in Raleigh, North Carolina. Investors’ preference for these stocks reflects the “risk-on environment we’ve seen in the past few months.”
Teal’s fund includes companies with high operating leverage, though it also considers other criteria, he said. “You need to be a little cautious about keeping a balance” between leveraged equities and more conservative strategies that focus on higher returns on equity and dividend yields.
Investors also may question whether the momentum in these groups will continue amid concerns about fiscal and political strife in Washington, according to Cliff Remily, executive vice president and portfolio manager at Pacific Investment Management Co. in Newport Beach, California, which oversees $1.8 trillion in assets. “The risk to the downside is pretty dramatic, so investors need to ensure they’re getting compensated for that.”
President Barack Obama urged Congress on Feb. 5 to postpone automatic spending cuts scheduled to begin March 1 to avoid “real and lasting impacts” on U.S. expansion. He signed a compromise into law Jan. 2 that averted income-tax increases on most Americans and delayed the cuts in what’s become a fiscal showdown related to raising the U.S. debt ceiling.
While Remily prefers a trifecta of improving operating leverage, top-line growth and attractive multiples in his portfolio picks, these baskets are “completely relevant” to gauge investors’ appetite for risk and their expectations for economic growth, he said. “In hindsight, it would’ve been great to invest in these groups about six months ago.”
If the economy weakens, as it did in 2011 and 2012, the rally in stocks with high operating or financial leverage could stall, Teal said. Those slowdowns were marked by a “flight to safety and quality” in the market, he said. Now sentiment is changing as improvements -- particularly in housing and employment -- appear to be “a bit more lasting than in the past two years,” Ghriskey said.
“The market is indicating that economic improvement appears to be accelerating somewhat,” which has made investors comfortable with “more risky propositions.”
--Editors: Melinda Grenier, Mark Rohner