Goldman Sachs Group Inc. has a compelling idea for how to navigate the current bout of stock market volatility: Focus on high-quality companies that can protect their profit margins as the economic cycle matures.
There are dozens of these high-quality stocks to choose from, including Apple Inc. and Alphabet Inc. (Google’s parent company). But one name stands out for being particularly well suited: O’Reilly Automotive Inc., a retailer of auto parts and tools for the do-it-yourself and professional-installer markets.
The company operates 5,190 stores in 47 U.S. states, and clearly benefits from a humming U.S. economy and busy roads.
O’Reilly Automotive generated a profit of US$366-million in the third quarter, up 29 per cent over last year (U.S. tax cuts also helped, of course), while sales at stores open for at least one year increased 3.9 per cent. The company is on track to open a net 200 new stores in 2018.
How does this success translate into high quality?
Goldman Sachs compiled a list of U.S. companies within the S&P 500 that have strong balance sheets, stable sales, growing earnings per share, high return on equity and a track record of relatively mild sell-offs. These companies also enjoy high gross profit margins and can pass along higher input costs to their customers, which is a nice advantage when wages are rising and global tariffs are increasing the cost of imports.
Using a quality scale of 0 to 100, Goldman Sachs gave O’Reilly Automotive a score of 94. That is the top score among the 50 stocks in the high-quality basket. It is slightly higher than Mastercard Inc. and Visa Inc. (each scored 92), and well above the average of 81 for the basket and 52 for the entire S&P 500.
A high score doesn’t necessarily translate into outsized expected returns. Instead, it reflects the extent to which a stock fits in with high-quality stocks.
Morgan Stanley took a similar approach in a recent note to clients. It also identified O’Reilly Automotive within a list of 32 companies that have pricing power, underscoring its attractiveness in the current environment.
“DIY auto is less discretionary, less promotional, and competitive pricing is generally benign,” Simeon Gutman, a Morgan Stanley analyst, said in a note.
He added: “We believe that DIY auto is one of the better positioned retail segments under recent and proposed tariffs. In particular, we believe the ‘do it for me’ side of the business [parts supplied to service centres] has the best chance of increasing prices as parts installers should be able to pass costs on to end consumers, who have few alternatives.”
This approach to stock-picking comes amid considerable turbulence in the stock market, as investors react to rising interest rates and no signs of easing trade tensions between the United States and China. The S&P 500 approached correction territory last Friday when it registered a drop of 10 per cent from a recent high (on an intraday basis).
Add in the fact that home-building stocks in the S&P 500 have tumbled as much as 40 per cent this year, the price of copper has fallen 19 per cent since June and the yield curve is flat, it’s no wonder that many observers believe the economic expansion may have peaked.
Economists at Goldman Sachs, for example, expect U.S. gross domestic product growth will slow from 3.5 per cent in the third quarter, at an annualized pace, to 1.6 per cent in the fourth quarter.
“In addition to concerns about economic growth, investors and managements have focused on margin pressures from rising wages and other input costs,” said David Kostin, chief U.S. equity strategist at Goldman Sachs.
Be warned, though, that high-quality stocks haven’t exactly gone on sale during the recent volatility.
Goldman Sachs’ basket of 50 stocks is up more than 8 per cent this year. More specifically, O’Reilly Automotive has fallen a mere 5 per cent in October – less than the S&P 500 – and is up a remarkable 36 per cent in 2018.
Still, if markets turn rocky again, expect this outperformance to continue.
David Berman