By Tim Mullaney
Stocks with higher profit growth rates tend to be more expensive — that is, to trade at higher multiples of their projected (in this case, 2020) profits — but growth stocks have risen 77 percentage points more than value stocks throughout the long recovery from 2008’s financial crisis.
The reason is really simple, Goldman strategists led by David Kostin say: In a slow-growth economy, companies that can boost profits rapidly are rare, so people pay up for them.
“During the last 35 years, stable growth stocks have outperformed during times of economic policy uncertainty,” Kostin’s team writes. “If uncertainty remains elevated ahead of next year’s U.S. elections, investors will likely continue to reward the stocks with the most stable historical earnings growth.” .
The trick of betting on growth is that high valuations can be volatile, Kostin’s team says. As the economy slows, from last year’s 2.9% growth rate to the 2.3% Goldman predicts for this year and 2.1% next year, markets tend to beat up companies whose earnings growth is more volatile.
An Apple /zigman2/quotes/202934861/composite AAPL +0.0000% that has a soft quarter in China, for example, which happened during the manufacturing-led slowdown of 2015-2016, get beaten up at times like that.
That leads Goldman to push its clients now toward growth companies that have been more stable over time, even though they are 23% more expensive, as a group, than the market, Kostin said. In tech, that points Goldman toward Alphabet /zigman2/quotes/205453964/composite GOOG +1.85% and a raft of payment-processing companies, led by Fiserv /zigman2/quotes/204817680/composite FISV -0.25% and Amdocs /zigman2/quotes/202810519/composite DOX -1.77% .
Big retailers like Walmart /zigman2/quotes/207374728/composite WMT -0.40% and Home Depot /zigman2/quotes/208081807/composite HD +0.14% and brands like McDonalds /zigman2/quotes/203508018/composite MCD -0.62% and Domino’s Pizza /zigman2/quotes/201587798/composite DPZ -0.43% pass Goldman’s earnings-stability screen but are more expensive.
Morgan Stanley’s caution
That’s not how it looks to Morgan Stanley’s Michael Wilson, though. “Overpaying for growth remains the biggest risk,” he wrote on Monday.
Wilson’s take on the economy is that last year’s near-3% growth was a mirage purchased by the 2017 tax cut. The gusher of money caused small excesses, or bubbles, in corporate investment and inventory building that needed to be offset by slower growth this year, he said, a pattern that shows up especially in slow inventory growth the last two quarters.
He thinks this payback is not near its end.
This means profit growth is likely to be near zero for the next 12 months, Wilson said. And that means the premium people have been paying for growth is untenable, he argues.
That leads Wilson to a different list of stock picks than Kostin’s.
His top pick in tech is Microsoft /zigman2/quotes/207732364/composite MSFT +0.76% , a stock this column called (correctly, for now) the best of the FAANG stocks in July 2018 for much the same reasons — modest price combined with a secular opportunity in corporate America’s shift to cloud-based computing.
He also tabs Walt Disney /zigman2/quotes/203410047/composite DIS -0.73% (also on Kostin’s screen), Procter & Gamble /zigman2/quotes/202894679/composite PG +0.75% , and insurance company Progressive /zigman2/quotes/202480455/composite PGR -0.71% .
For most small investors, the game is more about selecting mutual funds than stocks. And even there, the signals are mixed, since the best performing sector funds this year are in technology, which is a growth-dominated area, and real estate, a value bastion.
And for most investors, it means looking past the immediate problems of right now. This week’s trade disputes and earnings reports will be in the rearview mirror soon enough.