Goldman Sachs has a number of model portfolios based on investment themes and strategies that have outperformed the market in recent years. One that looks especially attractive in the current macro environment is their basket of 50 stocks with low labor costs. Wages are now rising at the fastest pace so far during the current economic expansion, creating an growing drag on corporate earnings. Companies with below-average labor costs as a percentage of sales thus should have above-average odds of maintaining solid profit margins.
The stocks in Goldman's low labor cost basket include these seven: Discover Financial Services (DFS), Anthem Inc. (ANTM), Align Technology (ALGN), A.O. Smith Corp. (AOS), Masco Corp. (MAS), Avery Dennison Corp. (AVY), and AES Corp. (AES). This is the second of two articles on that portfolio, and our previous report discussed seven other stocks, as well as Goldman's methodology and the recent performance of this investment theme.
7 Low-Cost Cost Outperformers
(Stock Price Gains, YTD 2019)
- Discover: +18.2%
- Anthem: +17.3%
- Align Technology: +19.7%
- A.O. Smith: +20.2%
- Masco: +27.9%
- Avery Dennison: +15.7%
- AES Corp.: +19.0%
- S&P 500 Index (SPX): +9.5%
Source: Yahoo Finance; computed through the close on Feb. 14.
Significance For Investors
Earnings forecasts for the S&P 500 companies are deteriorating rapidly in 2019, raising the specter of an earnings recession in which profits actually will be lower than in 2018. Morgan Stanley has been sounding this alarm for several months, and consensus estimates from other firms are now moving downward as well.
A recent survey of business economists, as summarized in our previous report, finds an all-time record high 58% noting that rising wage rates are a key problem for their companies, while only 19% indicate that their firms have dared to pass along these higher costs to customers through higher prices. In the absence of pricing power, companies with low wage bills relative to revenues will suffer the least damage from rapid wage inflation.
Anthem is a leading health insurance and health benefits management company. It offers superior metrics versus the median S&P 500 company along several dimensions, per Goldman: labor costs as a percentage of revenue, 4% vs. 14%; projected revenue growth in 2019, 10% vs. 4%; projected EPS growth in 2019, 19% vs. 7%; and forward P/E ratio, 16x vs. 17x. Anthem also beats the median company in the basket on the first three measures, and equals it on the last. Goldman used consensus estimates for revenue and EPS growth.
Discover issues credit cards with the Discover and Diners Club names, is the parent of PULSE, the third-largest debit card and ATM network in the U.S., and also offers online banking and lending services. Labor costs are 7% of revenues. Based on several metrics, such as a forward P/E of 8x and a PEG ratio under 0.5, Discover is widely viewed as a value stock. However, it also has significant growth opportunities in the booming market for electronic payments, as an established major player whose customer base and footprint of accepted locations are also expanding, per Seeking Alpha.
While the low labor cost theme fits the current macro environment, numerous other factors also drive the profitability of these stocks. For example, both Anthem and Discover are in highly regulated markets, where public policy has a large bottom line impact. Meanwhile, the profits of financial firms such as Discover tend to increase as interest rates rise, so the recent dovish turn by the Federal Reserve should be a negative development. Investors must assess how important labor costs are in the total picture for a given company.