GOLDMAN SACHS: An investing strategy that's been left for dead is now poised to triple the market's returns. Buy these stocks to profit from the reversal.
- Value stocks have underperformed their growth counterparts throughout the 10-year bull market. It's been even more noticeable since the beginning of May, when expectations of an economic slowdown and interest-rate cut began to build.
- According to Goldman Sachs, there's now a wide valuation gap between cheap and expensive stocks that could close in favor of bargain hunters.
- Goldman's equity analysts updated their basket of cheap stocks with the highest expected returns relative to their six-month implied volatilities.
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Bargain hunting in the stock market isn't what it used to be.
The strategy of buying stocks that are trading cheaply relative to the broader market - so-called value investing - has lagged since the financial crisis. In this lengthy bull market, investors have earned greater returns by buying richly valued stocks that hold the promise of strong earnings growth, particularly those in the technology sector.
This dynamic has notably been at play since early May, when investors began to reassess their expectations for economic growth and the Federal Reserve this year, according to equity strategists at Goldman Sachs.
As investors priced in higher odds of interest-rate cuts this year, they flocked to growth stocks - the favorites they had come to rely on for strong returns. They also favored stocks that exhibited low volatility over those with wider price swings.
And so, once again, value investing lagged behind.
But this could soon change, says David Kostin, Goldman's chief US equity strategist. His bull case for value stocks is underpinned by how much more cheaply they're trading compared to the rest of the market: a 65% discount to expensive stocks based on price-to-earnings ratios. This discount is in the 4th percentile relative to the past 35 years, Kostin said.
"A wide distribution of P/E multiples has historically presaged strong value returns," he said in a recent note to clients.
It would take more than this historical pattern to trigger a rally in value stocks. Kostin said investors would need to also be injected with optimism about future economic growth before they flock to value. They've already sent stocks to new highs based on the prospect of the Fed's intervention. But, according to Kostin, there's still a ways to go before actual expectations for the economy improve and undervalued stocks become fashionable again.
To identify stocks that would benefit from this shift, Goldman's equity analysts updated their basket of stocks with high Sharpe ratios. Stocks in this cohort characteristically have higher expected returns relative to their six-month implied volatilities. The updated list includes a 'quality' screen for stocks with healthy balance sheets.
The median stock in this basket has underperformed the S&P 500 by 13 percentage points this year, Kostin said. This means that they could be the perfect candidates to buy cheaply.
On top of all these characteristics, Kostin forecasts that the median stock in this basket will deliver triple the returns of the "typical" S&P 500 company with similar implied volatility (23% versus 7%).
The stocks where Goldman sees the highest earnings-related upside relative to the consensus price targets are Western Digital, Qualcomm, Halliburton, Marathon Petroleum, Salesforce, Facebook, Microchip Technology, Alliance Data Systems, and Macerich.