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I had a couple of interesting conversations recently, centering on the US debt ceiling and the potential for default. One friend asked what stocks he should short in anticipation of the US defaulting, so I took him through a story about how things could play out and how he should set up his portfolio.

But at the end, I had to explain that realistically, a default is unlikely. Indeed, one should find comfort in the thought that US political leaders understand the potential economic consequences of a default, and would not necessarily allow such an event. For reassurance, read Mr. Gordon’s article on the bond market (click here for article).

Yet, a cut in the rating of US debt is not out of the question as S&P explained on Thursday. Not surprisingly, given the current attitude toward government debt, a band-aid would not be sufficient, where a tourniquet is needed to keep America’s sterling credit rating.

Let’s say for a moment that the US avoids default (which is most likely), but its credit rating still gets hit (also unlikely, but go with it). We know that interest rates would head higher, and this could threaten the recovery. Granted, the Fed has indicated a willingness to provide more liquidity to the system if necessary, but I wouldn’t count on its effectiveness if such a plan were to be adopted.

Clearly, a derailed recovery could wreak havoc on the financial system. Anticipate more defaults, foreclosures, repossessions, etc. That stated, investors might want to consider steering clear of this area, or consider the ProShares Short Financials ETF (NYSEARCA:SEF). Exceptionally risk-tolerant investors who are adamant in their belief that financial stocks will fall might prefer the ProShares UltraShort Financials ETF (NYSEARCA:SKF).

That part was relatively easy to see. Now, let’s look for companies that would likely get hit harder than others if interest rates suddenly jumped. Let me preface this with the caveat that I’m not saying that anyone should take steps to go out and short these companies, but simply to reconsider exposure to these companies.

What are some of the characteristics that might lead these companies to get hit harder than others?

  • Perhaps some of them are overvalued, and a spike in interest rates provides the impetus for a pull-back in the share price.
  • Perhaps they have a lot of debt, which might be manageable with the marginal economic growth now, but could prove troublesome if business conditions deteriorate.
  • Perhaps they have considerable historical stock-price volatility, and would generally get nailed from a decline in the broad market anyway.

Each one of these factors could hurt stock prices. I look for companies that hit the trifecta.

Searching for the Trifecta

To construct this screen, we begin by omitting the finance sector. Next, we filter for companies that have high valuations. Specifically, we focus on stocks with P/E and P/Sales ratios that are more than 50% greater than their industry averages. There is nothing special about setting the bar here. It could be lower or higher.

What matters though, is that it is set to some magnitude greater than the industry norm. After all, we do not want to include companies that are just a touch more expensive than their peers; we want names that are a lot more expensive. As of Friday, this leaves us with a list of 147 names.

Next, we want companies that have a high debt level. We focus on firms with debt to equity ratios that are also well above (say, 50%) the norms for their respective industries. This leaves us with a list of 18 names. Apparently, it did not take long for us to arrive at a manageable list, so I will provide it here:

  • Cavco Industries, Inc. (NASDAQ:CVCO)
  • Golar LNG Limited (NASDAQ:GLNG)
  • GNC Holdings Inc (NYSE:GNC)
  • Illumina, Inc. (NASDAQ:ILMN)
  • Optibase Ltd. (NASDAQ:OBAS)
  • VeriFone Systems, Inc. (NYSE:PAY)
  • PACCAR Inc (NASDAQ:PCAR)
  • Potash Corp. (NYSE:POT)
  • Polypore International, Inc. (NYSE:PPO)
  • Pioneer Southwest Energy Part (PSE)
  • Rovi Corporation (NASDAQ:ROVI)
  • Sequans Communications SA ADR (NYSE:SQNS)
  • Sensata Technologies Holding (NYSE:ST)
  • Questar Corporation (NYSE:STR)
  • Suncor Energy Inc. (NYSE:SU)
  • TransDigm Group Inc. (NYSE:TDG)
  • Valhi, Inc. (NYSE:VHI)
  • Verisign, Inc. (NASDAQ:VRSN)

What about stock-price volatility? We want to identify stocks that are more volatile than the overall market. To accomplish this, we filter for stocks with a beta at least 50% over the market. This slashes our list to only four names, for further review:

  1. Golar LNG Limited (GLNG) is a liquefied natural gas company with headquarters in Bermuda. In addition to the factors in our screen, another reason to be cautious of this company is in terms of management effectiveness: According to Reuters, Golar’s figures for Return on Assets, Return on Equity, and Return on Investment all pale in comparison with the industry average. Two other considerations that are noteworthy: Analysts have been trimming their EPS estimates. That is of particular concern, given that the company has a history of missing estimates.
  2. California-based VeriFone Systems, Inc. (PAY) addresses issues related to secure electronic payments. Its historical stock volatility is considerable. In an industry with an average beta of 0.82 according to Reuters, PAY’s beta is a huge 2.00. Looking past the screen factors, we see other reasons for concern. The company’s profit margins are narrower than those of its peers, on average. For example, according to Reuters, the company’s operating margin was about 12.4% in the trailing twelve month (TTM) period, while the industry norm was approximately 24.2%.
  3. Polypore International, Inc. (PPO) is another technology company, but this North Carolina-based firm focuses on separation and filtration processes. Think things like medical filtration systems. In general, the firm has been doing a good job of growing its revenue and earnings, but all this good news already seems priced in the stock: Its valuation metrics (P/E, P/Sales, P/Cash Flow, P/Book Value, etc.) considerably eclipse the industry averages. Further, its forward P/E, which is based on earnings estimates for the current year is about 31, also above the industry norm of 24. In addition, its PEG ratio (forward P/E divided by long-term EPS growth rate) is a bit lofty, at 1.7.
  4. Canada-domiciled Suncor Energy Inc. (SU) in an integrated energy company, which has been posting revenue and earnings growth rates that surpass its industry peers, according to Reuters. Yet, as with the rest of the industry, its profit margins have come under pressure of late. For example, its operating margin stood at 13.9%, down from a five-year average of 14.4%. By comparison, the industry’s TTM average is 7.6%, versus a five-year reading of 18.7%. Sure, SU has debt readings that easily eclipse its industry (debt/equity of 0.30 versus an industry reading of 0.15), but the key issue with SU is valuation: Its P/E ratio stands right around 20, relative to an industry average half that.
Source: If Interest Rates Increase: Stocks to Watch for Downside Risk