Weekly Chartology; Goldman Introduces Its Own Version Of Rosenberg's SIRP For A Low GDP Growth Environment
In a surprising act of lucidity, David Kostin recently reduced his 2010 S&P target from 1,250 to 1,200. Now, the Goldman strategist has penned his own version of David Rosenberg's SIRP (Safety and Income at A Reasonable Price), by introducing two strategies for a low GDP environment: Low Operating Leverage And Dividend Growth (LOL-DG - yes, we prefer Rosenberg's acronym).Hopefully, this means that the GARP abortion is finally dead and buried.
Kostin clarifies this new recommendation, after various client meetings:
Clients were most interested in discussing our recommendation to buy stocks with low operating leverage and sell firms with high operating leverage. The weak US GDP growth forecast and specter of deflation means top-line sales increases will be hard to achieve. Firms with low operating leverage should benefit from stable margins and less risk of negative EPS revisions and should outperform companies with high operating leverage. We suggest buying a basket of 25 stocks with low operating leverage (Bloomberg ticker: <GSTHOPLO>) and selling a sector neutral basket of 25 companies with high operating leverage (Bloomberg: <GSTHOPHI>). The long/short trade has returned 1.6% since initiation at the start of the week.
The intuition behind our low vs. high operating leverage trade has two components: First, Goldman Sachs Economics forecasts US GDP will post average annual growth of 1.9% in 2011, near the low of the 51 economists surveyed by the Blue Chip Economic Forecast. Consensus growth forecast averages 2.8%. The earnings models that equity analysts use to forecast EPS estimates incorporate a GDP growth rate assumption. If consensus 2011 GDP growth (2.8%) falls towards the Goldman Sachs estimate (1.9%), then consensus sales projections will have to be slashed because GDP and sales are correlated. As a result, earnings estimates will also have to be reduced. Negative EPS revisions should be more modest for firms with low operating leverage compared with companies with high operating leverage. EPS revision differential should drive relative share price performance.
Second, profit margins have already returned to near-record levels for the overall market (2Q reached 96% of prior peak). The prospect that profit margins will continue to rise meaningfully from already elevated levels is becoming more difficult to embrace given a weak US economy will retard top-line revenue growth. Significant cost savings have been realized during the past year but incremental margin improvement will be more challenging.
Buy High Dividend Growth: Lower potential upside to the US equity market favors buying stocks offering a combination of both high initial dividend yield and strong dividend growth. Our basket of 40 S&P 500 stocks have an estimated cash-return-on-cashinvested of 3.9%, more than 200 bp higher than the equal weighted S&P 500. The stocks have a larger market cap, higher current annualized dividend yield, and faster expected dividend growth than the equal-weighted S&P 500.
Essential beach reading: Our 2Q 2010 S&P 500 Beige Book
We included verbatim excerpts from 56 company conference call transcripts in our quarterly S&P 500 Beige Book. We highlighted 5 key themes:
Theme 1: Uncertain economic outlook but Europe better-than-feared. Managements were positive on 2H outlook but tempered it with caution around the consumer. Views differ across sectors, with Industrials and Materials generally more positive and Health Care more conservative. Examples: F, MCD, NKE, KMB, JPM, MS, UNH, JNJ, ETN, FDX, GE, BA, V, XRX, FCX, OI.
Theme 2: Focus on margin improvement. Corporate margins continue to benefit from 2009 cost cuts and lean hiring. Many firms guided to flat or slightly higher sequential margins in 2H and seem to be placing a higher priority on margin levels than other performance metrics. Managements indicated that much of the previous cost cuts will remain “permanent”. sExamples: NKE, CL, COP, MHS, CMI, GE, LMT, WM, XRX.
Theme 3: Disciplined hiring practices. Corporations remained tentative in their hiring practices, waiting for stronger signs of stabilization. Many firms cited high unemployment and weak sentiment as reasons for caution. Lean payrolls may help companies protect their margins in a slowing economy. Examples: AMZN, KMB, MMM, UPS, PAYX, AKS, ETN.
Theme 4: Use of large cash balances. Corporate cash balances remain high and companies continued to pay down debt, raise dividends, and buyback stock in 2Q. The desire to expand margins and capture limited growth opportunities has curtailed investment spending. Examples: F, CAT, GE, UPS, AMZN, PEP, MMM, X.
Theme 5: Mitigated impact from currency moves. Many firms hedge their near-term FX exposure. Managers noted that a persistently strong USD could be a headwind. If the USD weakens against the Euro it could be a mild positive for profits as hedges roll off. Examples: KO, FDX, UPS, MCD, NKE.