7 investment strategies when rates are rising

Buy Banks, Funds and Insurance

Hugh Dive

The companies that will perform well in a rising interest rate environment fall into the following categories:

1) Major trading banks should see a benefit from rising rates due to a fast-growing spread between the short-term interest rates that they pay depositors and the rates at which they can lend money.

2) Fund managers such as BT could see increasing inflows into higher margin equity funds, as investors aggressively sell out of bond funds as their unit prices fall in response to rising yields.

3) Companies that hold significant cash balances due to the nature of their business such as insurers QBE and cash handlers like Computershare and Flight Centre. Computershare on average holds US$15 billion in client balances generally from dividends yet to be paid to investors, but on average since 2011 has only earned 1.5% per annum on this amount. QBE Insurance will be one of the biggest beneficiaries on the ASX from rising bond yields, though given the company’s somewhat tortured relationship with investors. As an insurer, the company holds US$23 billion in cash and short dated debt as a “ float” (this occurs as premiums collected before claims are paid out). Whilst QBE has managed this float well, nevertheless it has generated meagre returns in this period of low rates. A mere 0.5% increase in interest rates will add over US$100 million to 2017 net profits or boost reported profits by 11%.  Additionally Australian investors will see a translation benefit from the company’s USD-denominated earnings if rising bond yields continue to weaken the AUD.

Invest in companies with exposure to construction

Dean Fergie, Cyan Investment Management

It is important to consider the correlation and interdependence between macro economic factors; single factors rarely move uniquely.  If interest rates do continue to rise (as they have been) in would indicate a loosening of monetary policy and a pro-growth, high-spending political and economic environment.  Initially, and understandably, the bond-proxy and income stocks have sold-off markedly; property trusts, infrastructure and, in Australia, the major banks and telcos.  These liquidated funds would quite rightly be expected to rotate into higher growth economic plays; commodities, building materials, construction firms, consumer discretionary and a smattering of industrials. We think the growing new-tech businesses are likely to be reasonably unaffected by macro-economic movements.

In a pro-growth, rising interest rate environment we think it's of value to have exposure to net-cash businesses with construction leverage. SRG Group (SRG) has over $26m in cash on its balance sheet and is a global player in the infrastructure sector designing bridges, dams, silos and tanks and provides a wide range of post-tensioned concrete products for the building industry.  This business is preforming ridiculously well currently (PBT in FY16 was up 50%) and a well-timed and opportunistic diversification in wall building might be an added bonus for SRG!

Value stocks, cyclicals, banks and larger companies will work.

Chris Prunty, Fund Manager, Ausbil Micro Cap Fund

In investing, and life, it doesn’t pay to throw yourself in front of a bus.  Share prices trend.  They over-react.  Right now REITs, Utilities and interest rate sensitive stocks are trending down as rates trend up.  Value will emerge but more often than not prices overshoot.  If you’re nimble you could sell these some or all of these stocks but more likely the lesson is to be patient and let the trend exhaust itself before starting to buy these sectors.  All of this is a long-winded way of saying a shift in the macro environment influences where we allocate the incremental dollar.  No need to throw it at something that is not working. 

Value stocks, cyclicals, banks and larger companies will work.  REIT’s, Utilities, growth stocks and smaller companies will struggle.  Some of this is just maths; high PE stocks are more sensitive to rises in the cost of capital.  Some of this will be driven by the assumption that a rise in interest rates will be accompanied by an increase in global growth which will disproportionately benefit cyclical stocks as their earnings recover.  I’d caution about getting too carried away with sector-based or thematic investing, however, as we’re really talking about 3-6 month trends.  Over a more medium term timeframe good old fashioned stock picking will still work.  As the Silver Fox, Peter Lynch, said “if you spend 13 minutes a year on economics, you've wasted 10 minutes.”

The market is throwing up heaps of opportunities in the small cap space right now.  We like Smart Group, Hansen Technologies, Trilogy International, RCG Group and Webjet among others.  The last couple of months has seen carnage in the well-owned mid and small cap industrial space – some of it for stock specific reasons – but also because there has been a retreat of ‘large cap refugees’ out of small caps. A ‘large cap refugee’ is a manager who has tired of delivering low single digit returns for the last 3 years and has come down to play in the small or mid caps sector to ‘enhance’ returns.  We don’t own any of these, but stocks representative of this behaviour include Aconex (down -45% from its peak), Altium (-21%), TPG (-45%) and Mayne Pharma (-22%). All are growth juggernauts with great stories and global addressable markets and they are certainly more exciting than the typical ASX100 stock. It’s not hard to be enticed by these names until something like APN Outdoor’s spectacular -35% in-one-day implosion reminds the large cap refugees of what small cap volatility looks like. The point of the story is, should banks and resources find favour, as discussed above, then large caps will start to work which could see further selling of small cap growth names; this will be painful short-term but sets up attractive medium-term opportunities.