Companies with healthy balance sheets like Home Depot and Nvidia are investors’ best bet as the rest of corporate America loads on debt to unsafe levels even as the Federal Reserve continues hike rates, according to Goldman Sachs.
“Strong balance sheet stocks have historically outperformed weak balance sheet stocks during environments of rising leverage,” wrote David Kostin, the investment bank’s chief U.S. equity strategist. “We expect financial conditions will continue to tighten from record easy levels. … We have recommended investors own strong balance sheet stocks given the backdrop of record corporate leverage and Fed tightening.”
Among stocks with the best balance sheets are home improvement retailer Home Depot and chipmaker Nvidia, Kostin added, arguing that the outperformance both companies have posted so far this year is likely to persist. Home Depot is up 5.4 percent since January, while Nvidia and the S&P 500 have gained 35 percent and 4.6 percent, respectively.
Part of the reason companies like Adobe and Costco may be set for outperformance is their ability to withstand rising interest rates. Borrowing costs have climbed over the past 12 months as the Federal Reserve moves to rein in its expansive purchasing program, originally introduced to help support the economy during the financial crisis.
Meanwhile, net debt to EBITDA, a measure of leverage used by Goldman, for the median S&P 500 company has reached a record level, according to the firm.
The yield on the U.S. 10-year Treasury note has climbed roughly 100 basis points to 3 percent in less than one year. The note’s rate is important given its role as a benchmark for mortgage rates and other financial instruments.
In their next move to normalize policy, Fed members are expected to hike the federal funds rate another 25 basis points on Wednesday, at the end of their two-day monthly meeting in Washington.
For its part, Goldman Sachs economists believe Fed Chairman Jerome Powell and his colleagues will hike rates three more times before the end of the year, more times than Wall Street is currently estimating.
“In contrast with history, many of the companies with the strongest balance sheets today are also the companies with the strongest growth,” Kostin added. “In our base case, a healthy economy will lead the Fed to tighten financial conditions, lifting interest costs. If economic growth slows, however, currently healthy interest coverage ratios will weaken as earnings decline. Both environments should benefit firms with strong balance sheets.”