On Thursday, May 24th, I authored the first in a two part series covering stocks that should disproportionately benefit from an expanding U.S. economy. The premise of these articles is simple. Much like adding external financial leverage to an investment portfolio will magnify returns, buying companies with high levels of financial leverage or operating leverage should also produce outsized returns when the economy is expanding and markets are rising.
In the first article in this miniseries, I discussed companies in the Goldman Sachs Weak Balance Sheet Basket. This group of stocks was constructed by screening the S&P 500 (SPY) constituents for companies with a low Altman Z-Score, a formulaic scoring methodology used to predict risk of bankruptcy. This article examines the Goldman Sachs High Operating Leverage Basket.
The construction of this basket is even more simplistic, owning stocks that have a high degree of operating leverage relative to their sector. For this basket, the degree of operating leverage is defined as the ratio of revenue after variable operating costs to revenue after both variable and fixed operating costs. It stands to reason that in an expanding economic environment, firms with high operating leverage should expand margins and grow earnings faster than the market as a whole.
The opposite of course is true when economic growth is flagging as firms with high operating leverage see more rapid margin compression and contracting earnings. This is visible when comparing this basket of stocks versus the S&P 500 at large. The beta of the High Operating Leverage Basket relative to the S&P 500 is 1.32. (Here beta is measured as the covariance of monthly returns between the High Operating Leverage Basket and the S&P 500 divided by the variance of the monthly returns of the S&P 500).
For investors who believe that we are in a market upswing not yet fully appreciated by the market. The stocks listed below should outperform do to their higher degree of operating leverage:
As I indicated in my previous article on companies with high financial leverage, a momentum trade also exists between low volatility stocks (SPLV) and stocks with high operating leverage. This idea is readily executable. Comparing the returns between the high operating leverage basket and the low volatility index, the group of stocks which outperformed over the trailing one month tends to outperform over the following month. Using this simple heuristic as a guide to tactical asset allocation has generated alpha since the advent of the Goldman Sachs High Operating Leverage Basket in July 2004.
Investors seeking to add high beta stocks in this market environment should understand that a switching strategy between low volatility stocks and stocks with higher operating leverage has strongly outperformed the S&P 500 with a lower variability of returns since the summer of 2004. In my recent discussion on the long-run outperformance of low volatility stocks, I make it clear of my preference for these higher quality companies over the long run; however, when the economy is expanding these more leveraged companies (whether the leverage is financial or operating) should outperform the broader market. I hope this article arms Seeking Alpha readers with a list of companies to further examine if they are tactically bullish on the domestic equity market, and that they now have a tool to think about the momentum element of this trade.
Absent exchange traded funds that replicate neither the Weak Balance Sheet Basket nor the High Operating Leverage Basket, I will be providing a more detailed opinion on the companies that are in both lists, and likely to see the largest valuation swings, in a forthcoming article.
Tabled below are the monthly returns of the Goldman Sachs High Operating Leverage Basket, the S&P 500 Low Volatility Index, a momentum portfolio that toggles between the two based on trailing outperformance, and the returns of the S&P 500 for readers more interested in this momentum trade.