My wife tells me that interest rates are "the most boring conversation topic in existence." While the general public may agree, here at SeekingAlpha we love the discussion and it has been getting quite a bit of steam lately. The investing world is worried that when rates go up, the stock market will tank and investors will be in quite the pickle. However, my Value Investing colleagues and I believe that it is exactly the opposite reaction that we should be having! Here is why the rising interest rate environment will be a blessing in disguise and what you should do about it from a value perspective.
Everyone knows that interest rates are going up in the near future. We don't know when, but most of us know what will happen when Bernanke quits quantitative easing. In the long run a rise in interest rates is usually followed by a bull market and a strong economy. In the short term, higher interest rates mean a higher cost of capital for firms, higher expenses, fewer projects undertaken, and ultimately lower corporate profits. There are a lot of other factors in play (mainly concerning the FED's balance sheet), and generally they all lead to a short-term decline in the market once rates go up.
So how far up will they go? The current yield on the 10-Year Note is 2.6% while the past 40-year average is 7%. Before the recession in 2007 yields were sitting at around 4%, which is close to where they were in the peaks of 2010/2011. When Bernanke quits QE I think it is very reasonable to assume that rates will hit the 4% level very fast.
For this article I wanted to research what actually happened the last few times that interest rates rose significantly. Thankfully I didn't have to make all these graphs because BusinessInsider did a fantastic job of it. Here's what happened the last times the FED changed rates dramatically:
Unfortunately these pretty charts don't really tells us much about the future. Some of the graphs go up and some down, but there really is no clear pattern between them all. This is why I think it is extremely important to prepare for the worst (and what I believe is the most likely) scenario of a major stock decline.
How Value Investing Fits In
As a Value Investor I have been extremely disgruntled with this year's bull market. Don't get me wrong, 20%+ returns with (SPY) are fantastic, but how are we supposed to find any bargains in these types of conditions? In my last article: Why Value Investors Are Going To Cash I wrote about getting out quick before rates go up. I am currently sitting on a portfolio comprised mostly of cash and have no place to put it! A lot of the legendary Value guys are also going to cash to anticipate a juicy bargain season when rates go up. For example, Prem Watsa at Fairfax (OTC:FRFHF) is fully hedged:
"Our common stock gains in 2012 were once again substantially offset or eliminated by our hedging program. While this is disappointing, we continue to be comfortable maintaining our hedges because of all the uncertainties we see in front of us. In 2007, a major U.S. bank CEO famously said "as long as the music is playing you have to get up and dance". After the Lehman bankruptcy in 2008, this same bank needed $45 billion from the U.S. government to continue in business. Expensive Dance! We prefer to wait for the music to stop and not depend on the kindness of strangers to be in business."
Warren Buffett at Berkshire (BRK.A) (BRK.B) is also sitting on his biggest cash hoard ever, 49 BILLION! While Berkshire is obviously bigger than ever before, and therefore generating more cash than ever before, a $49 Billion cash position (after several major acquisitions this year) does imply he is having a hard time finding things to buy.
This is why my Value friends and I are extremely excited for when rates go up. While most people see a declining market as a reason to get out, we see it as the only acceptable opportunity to get in. While it is true that we want to find bargains regardless of market conditions, it has been very difficult to find them right now. We are hoping that once interest rates rise certain companies will fall and become attractive again. However, this does require a long-term mindset and a little bit of patience, of course.
How To Prepare
Step One: Get out of the market. It has reached a very high point and there are various reasons why I believe a few bear years are coming (see my last article).
Step Two: Start researching which companies you would like to buy once we see an overall drop in the market. This will prevent you from buying (or selling) anything out of impulse, and take away some of the noise from the game.
What my friends and I have been doing is making a list of 25 companies that we would like to buy if they drop to specific prices. These are companies with significant competitive advantages but that do dabble in debt to fund their projects or rely heavily on consumer debt.
We tend to gravitate toward large firms with good management and global operations. I'm not talking about the Coca-Colas (KO) or Intels (INTC) that basically print money and fund their operations with their cashflow, I am talking about the Fords (F) or Toyotas (TM) that are great firms but need constant financing.
I saw an article the other day that told investors to stay away from companies like the Fords and go for the Intels when rates go up. This is definitely the wrong advice to give as I believe we should be looking for the companies that will decline the most. Think long-term, and benefit from emotion filled temporary price swings in good stocks. Will the rising interest rates hurt Toyota's profits? They definitely will. But will Toyota likely innovate to reduce costs and sell more cars in the future? Absolutely. Furthermore, will investors likely oversell auto companies once bad news kicks in? I hope so!
Another category worth looking at is homebuilding. Any company that physically builds homes, or supplies homebuilding materials will decline with rising interest rates. Higher interest means fewer people buying houses and lower profits for homebuilding firms.
However, in the long run people will always need new cars and homes, and the most innovative companies in the industries will survive no matter what the interest rates are. Automotive and homebuilding are some of the industries where I believe people will overreact to bad news and possibly oversell. Look for the good apples in the bad industries.
To conclude, I caution investors who buy stocks right now. For the most part they are at their 52-week highs and a low will be coming soon! When that low comes be prepared to find bargains and hold on to them until they reach their intrinsic values. When interest rates rise I predict that the market will decline in the short term. And as always, read balance sheets not analyst reports!