Investors are always looking for the best return for the least amount of risk. And Goldman Sachs’ basket of stocks with high “Sharpe ratios” offers one possible solution.
The Sharpe ratio, developed by Nobel Prize winner William Sharpe, is defined as the ratio of a stock’s, fund’s or asset’s return (minus the risk-free rate) divided by its volatility. Goldman is using the prospective Sharpe ratio. That means they take the potential return of a stock to its average price target and divide it by the expected volatility over the next six months as reflected in the options market. The idea is to gauge how attractive a stock looks relative to the risk an investor may endure in holding it, or the risk-adjusted return.
Goldman’s Sharpe ratio basket has outperformed the S&P 500 64% of the time over semiannual periods since 1999, but has underperformed in 2020, gaining just 13% to the benchmark index’s 17% return. Goldman chalks up that underperformance to the basket’s “Value tilt” as value stocks have lagged this year. The firm notes, however, that the baskets—and value stocks—have outperformed since the U.S. election and Covid-vaccine approval, and should continue to if the firm’s forecast for “vaccine distribution and a sharp economic and earnings recovery” is correct.
The basket is sector neutral, which means that it will look like the S&P 500 on a sector basis. The difference is in the stock picking, and it picks a lot of value stocks. The basket includes insurers like Hartford Financial (HIG) (but no banks); health-insurer Centene (CNC); and Dish Network (DISH) in communication services. In the industrial sector, the basket favors defense stocks Northrop Grumman (NOC) and Lockheed Martin (LMT), which have Sharpe ratios of 1.
But the basket also has companies that don’t look like value at all. Merck (MRK), for instance, has a Sharpe ratio of 0.9 and is down 18% year-to-date. The stock has 21% of upside to the average analyst target, while its beta—or volatility relative to the S&P 500—is 0.4. A beta of less than 1 represents a stock less volatile than the index. Above 1 means it is more volatile.
Drugmaker Regeneron (REGN), meanwhile, has a Sharpe ratio of 1 and is up 31% year-to-date, but down 19% since November 6, the last trading day before Covid-19 vaccine producers announced high testing effectiveness, creating exploding economic expectations.
There’s also a healthy serving of highflying tech names on the list, including Alphabet (GOOGL), with a Sharpe ratio of 0.3, Salesforce (CRM) (0.6), Adobe (ADBE) (0.4), Microsoft (MSFT) (0.3), Facebook (FB) (0.5), eBay (EBAY) (0.5) and Activision Blizzard (ATVI) (0.3). Each of those stocks has gained at least 30% in 2020.
Overall, Goldman’s basket has 50 stocks with an average prospective Sharpe ratio of 0.5, better than the S&P 500’s 0.2.
Write to Jacob Sonenshine at [email protected]
