Thriving Investing While Interest Rates Rise

For over three decades, the interest rates on debts have been generally sloping downwards. This has been the status quo for so long that major banking houses like U.S. Bancorp need to conduct special training sessions to teach a new generation of employees that, yes, interest rates do rise. A lot of energy has been spent trying to figure out the sequence and degree to which the Federal Reserve will make the cost of money more expensive.

In my view, there are three things to keep in mind when thinking about rising interest rates.

First, the prices of individual stocks may come down a little bit if interest rates rise at a rate greater than expected. Some of this may be company specific, as the balance sheets of corporations finally start to get scrutinized with new assumptions of higher refinancing rates. Other times, it may be a more broad reaction, as investing in instruments like U.S. Treasuries start to look more attractive. The reason I use the qualifier “may come down” is because this assumes all things to be equal (which they never are) and it is certainly possible that positive news items such as tax cuts or a strong quarterly earnings season could more than compensate for a high rate hike. This is why my blog doesn’t cover short term investing—astrologizing about that kind of stuff is a mystery to me.

That said, there are two other things about interest rates that I do keep in mind.

There is a good chance that stocks which are often called “bond substitutes” because they generate reliable earnings and hold the dividends steady will be the biggest losers in a rising interest rate environment. By that, I mean that they are most likely to experience P/E compression which will prove disappointing when it is met with low growth.

Don’t get fooled into thinking that the prices of today have a sturdiness to them. This past July, Realty Income was trading at $71 per share. Now, it is down to $59. And that should be expected. Throughout the history of Realty Income, it traded at 15x its funds from operations. People discovered the reliable monthly dividend and took a liking to it, and bid the shares up to the stratosphere. Now, it earns $3.00 in funds from operations. This means that the stock ought to trade somewhere in the $45-$50 range. Interest continue to tug at REITs not because they are REITs, but rather, because they fall into the category of slow growth/high income which investors have a long history of budding down as fixed income investments become more attractive.

That doesn’t mean you can’t find good dividend deals out there. I continue to like GlaxoSmithKline as a cash cow trading at $39. It pays out a 5.3% dividend yield. The risk is that British stocks are disfavored because of Brexit and GSK’s dividend payout fluctuates alongside the operating results of the business so some years the dividend goes up and some years it goes down. The payout isn’t fixed—it ebbs and flows with actual performance. The traditional income investing class doesn’t like fluctuation of income, and therein lies the opportunity. Growth investors don’t want it, and the dividend isn’t reliable enough to attract the attention of the income crowd.

And lastly, my response to interest rates is to do what I’ve always done—look for risk-adjusted growth. When I think about investments meant to last decades, the question I pose is: “Which passive investment offers the greatest probability of growing future cash flows at the highest rate with the lowest risk of disruption to those cash flows while also trading at a reasonable price?” That inquiry does not change. There is a point—if we returned to the Volcker years and fixed income was paying something like 10%–where the focus would shift to bonds, but we aren’t there, and so I don’t analyze it.

This was actually something that was on my mind when I started the site in 2013. I was flirting with calling the site “The Conservative Dividend Investor” but I didn’t choose that name because, at the risk of pulling out the Book of Ecclesiastes on you, there is a season to everything. Stocks are usually the best place to look because business growth is hard to beat. But if stocks become sufficiently overvalued, or high-quality corporate debt yielded 8%, I’d roll with the changes and adjust to where the best risk-adjusted opportunities could be found.

If General Electric had corporate debt at 6.5%, or Wells Fargo offered high yielding preferred stock, I’d happily discuss that with you. I don’t cover common stocks because I’m ideological about them, but rather, I realized that business growth is where the greatest passive wealth gets created over the long haul and so I discuss accordingly.

Long story short, there about a dozen or so companies out there like Nike stock that have a high probability of growing earnings in the 12-16% range over the long haul. Whether interest rates are 3% or 6%, those businesses still create the most net-of-tax wealth. Sure, 12% Nike returns compared to 6% bond returns have a lower *relative attractiveness* than when 3% is the reference point, but it is still the greatest sum.

And, as I mentioned in the first part, since I don’t try to divine the short term markets, my only test is whether the price is reasonable at the moment I’m considering it. If it looks overvalued, I’ll look elsewhere or wait for it to come down. If it looks like a fair deal, I’ll strike upon that insight and not wait for something hypothetically better six months from now.

But that is my mindset as I contemplate higher interest rates. In the short term, I can’t imagine what countervailing forces will exist so I don’t care about the month-to-month fluctuations. I do think there is something to the notion that low growth dividend stocks are a bit pricey right now. But my primary focus is on the search for the best blend of high growth and low risk of earnings impairment, and that inquiry does not change if interest rates go up a few points.