While the market has surge higher since its March bottom, Goldman Sachs analysts said in a report this week that the market’s recovery has been uneven.
And that uneven recovery has made the difference in valuations among stocks the greatest it has been since the dot-com bubble.
Since the March 23 low, the S&P 500 is up around 32%, though it is still down roughly -13% from its February 19 high. However, amid this run higher, certain companies and sectors have risen far more than others.
To illustrate just how uneven the recovery has been, the median S&P 500 stock trades for 16 times estimated earnings over the next two years. But the median stock in the tech-heavy Nasdaq 100 trades at a 34% premium to that, while the median small-cap in the Russell 2000 trades at a roughly 40% discount.
And even within the S&P 500 index the valuation differences are staggering. The median stock in the 80th percentile of the index trades at 24 times estimated earnings over the next two years, while the median stock in the 20th percentile trades at just 10 times estimated earnings.
Since 1980, the average difference between the two has been 9 times earnings. Right now, it’s at 14.
“In contrast with expected growth, differences in the current profitability across U.S. stocks are much more stark and appear to explain the extreme current degree of valuation dispersion,” the Goldman analysts wrote in the report.
The analysts noted that when valuation dispersion has widened to such extreme levels in the past, those periods have been followed by the cheaper stocks rallying to catch up with the more expensive stocks – closing the valuation gap, which should happen again this time as the economy improves.
“Most of these inflections occurred near the trough of a recession or major economic slowdown,” the analysts wrote. “In these cases, low valuation stocks outperformed a rallying market as economic growth improved.”
While that doesn’t mean investors should dive into the bottom of the barrel with stocks that are cheap for a reason, the analysts found there are cheap stocks in the index that are worth a look.
And with that, the Goldman Sachs analysts screened for stocks in the fourth quintile of the S&P 500 by valuation. This quintile currently trades for a 25% discount to the broader index’s median.
The analysts came up with a list of 21 stocks that fit the bill of being cheap—but not too cheap—that are poised for outsized growth.
On the list are names like Best Buy (NYSE: BBY), General Dynamics (NYSE: GD), Gilead Sciences (NASDAQ: GILD), Oracle (NYSE: ORCL), Skyworks Solutions (NASDAQ: SWKS), and UnitedHealth Group (NYSE: UNH).
“Although these firms carry discounted multiples, most have stronger balance sheets, generate superior returns, and have faster consensus 2019 – 2021 earnings-per-share growth than the median S&P 500 stock,” the Goldman analysts wrote.
While Best Buy delivered somewhat disappointing earnings this week, reporting revenue and earnings fell in the first quarter despite an initial surge of shopping amid the coronavirus pandemic as shoppers set up their home offices and prepared for kids to attend school remotely, it also gained a few bullish upgrades.
Telsey Advisory Group raised Best Buy shares from Market Perform to Outperform on Tuesday, saying that the stock should continue to benefit from “the work-from-home trend, which will likely be here for a while, and the shift in spending toward home-related items, including electronics,” among other trends. And on Wednesday, CFRA reiterated their Buy rating on the stock and boosted their price target from $75 to $90 – 15% above the price as of this writing.
RBC analyst Michael Eisen is bullish on General Dynamics, initiating the stock this week with an outperform rating and a $157 price target – 13% higher than the current price.
The Pentagon has reportedly asked Congress to approve a bulk order for the first two Columbia-class ballistic missile submarines, in a deal that would be worth as much as $17.7 billion for General Dynamics.And the defense contractor said in its first quarter earnings call earlier this month that it has seen a $1 billion bump since the renegotiation of a $10 billion contract for Canada to sell light armored vehicles to Saudi Arabia.
JPMorgan analyst Mark Murphy recently upped his rating for Oracle from Neutral to Overweight, with a new price target of $55.
“During an economic expansion phase, there is a lot of net new software spend to pursue, and Oracle has been left behind with subpar growth,” Murphy said. “However, the opposite is true when the economy slows, and the creative net-new software spend dries up: companies growing 70% can slow 15% in a few quarters, and if they’re starting form 30 times revenues and an infinite cash flow multiple, there is essentially no floor below the stock. … [Oracle] is a business model which doesn’t bend much in the storm, and it is a more recurrent model today.”