Often enough, I have come across commentary from the market pundits warning that the blue-chip stocks could get hit the hardest when interest rates start to rise. Considering that utilities and consumer staple stocks have led the market rally this year, it is reasonable to conclude that an increase in the interest rates could lower the valuations of blue-chip dividend-paying stocks.
For a company like Hershey (NYSE:HSY) that is trading at almost 30x earnings (its highest valuation since the dotcom bubble years), an interest rate increase could prove to be the kind of catalyst that could jumpstart a "reversion to the mean" process for its valuation. The same storyline could apply to Realty Income (NYSE:O), which is trading at its highest P/FFO ratio in the past decade. Junk bond indices, certain energy MLPs, many REITs, and certain moderately to excessively valued blue-chip stocks are the types of companies that stand to experience a justified price correction when interest rates rise.
The rules are a little bit different for blue-chip companies like Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and ExxonMobil (NYSE:XOM) that are trading in a range from fully valued to slightly overvalued. That is because there is one unrealistic assumption that tends to dominate the discussions of interest rate risk to blue-chip stocks: it assumes that all other elements of the stock remain static. Almost all commentary on the intersection of blue-chip stock valuation and interest rate risk starts off with the phrase, "All else equal…" The thing is, all else is not equal.
I chose Coca-Cola, Johnson & Johnson, and ExxonMobil deliberately. In the case of Coca-Cola, the earnings per share increase by at least 7-8% in most years. In the case of Johnson & Johnson, the cash flow per share has increased at least every year since 1997. And, in the case of Exxon Mobil, the company's aggressive share repurchase program of $5-$8 billion per year almost guarantees that earnings per share will increase in any year in which there is no significant decline in the prices of commodities.
This has an important implication for investors in blue-chip stocks: the dependable earnings per share increases act as a countervailing force that can limit the impact of interest rate risk in a rational market.
Let us take a quick look at how this could play out in real life. Right now, Coca-Cola is generating $1.90 in profits. At $40.77 per share, that works out to 21.45x earnings. Next year, Coca-Cola is expected to earn $2.30 per share. If the interest rate risk pushed the valuation of Coca-Cola downward to 17.72x earnings, the company would still trade at $40.77 per share. From that moment on, your future returns would mirror the growth rate of the firm, adjusted for the "new normal."
A similar story plays out with Johnson & Johnson. The company is currently generating about $6.75 in cash flow per share. At $86 per share, that means the company is trading at 12.74x what it generates in cash flow per share. In 2014, some analysts estimate that Johnson & Johnson will generate $7.55 per share in cash flow. If interest rate risk caused the valuation of Johnson & Johnson to fall to 11.39x cash flow per share, the healthcare giant would still be at $86 per share.
As long as the company on your list is growing profits on a reliable basis over most three and five year rolling periods, you should be able to handle interest rate risk all right. Reliable 7-12% annual growth is a pretty good defense against the downward pressure of valuation multiples that can accompany rising interest rates.
If we encounter an environment where interest rates rise sharply, it is a realistic possibility that some popular dividend-growth stocks will experience a temporary decline in valuation levels. If that were to happen, we can adjust our behavior by adding to our positions or reinvesting our dividends.
The point is that the business fundamentals and operational health of the company would remain sound during such a sell-off. If we did see a sharp spike, it would provide a good opportunity for dividend investors to do what they do best: think like a business owner and focus on the cash dividends. If Colgate-Palmolive (NYSE:CL) and General Mills (NYSE:GIS) shareholders could focus on their dividend checks while Japan was bombing us and Germany was streaking across Europe during WWII (both of those companies maintained their dividends throughout the Great Depression and Second World War), modern-day dividend investors ought to be able to weather a little bit of interest rate risk.
Some investors have to fear justified price declines that could accompany a rise in interest rates. But if you own a high-quality dividend stock, you have two defenses against this risk. The first is that earnings per share growth acts as a useful shield that can offset a lower valuation multiple. The second is that if prices do fall by more than expected, the decline may very well prove to be irrational and provide dividend investors an opportunity to add to their positions. Growth in the range of 7-12% annually can overcome a lot of problems, and if you own blue-chip dividend stocks that do that, you should find yourself reasonably protected against the effects of moderately rising interest rates when they come.
Disclosure: I am long XOM, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.