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If you hold mutual funds that are allowed to invest in all kinds of stocks, what Alan Greenspan and the Federal Reserve decide to do this year and beyond should make little difference to your investment decisions. As a holder of a broad-based fund, you are doing more than just buying a bunch of companies: You also are investing in the brains of your fund manager. Part of the service you should expect is that your manager is able to anticipate changes in interest rates, or else to react to changes very quickly.
But if you invest in individual stocks or sector-based mutual funds, interest rates matter greatly, the same way they do to the manager of a growth or general-performance fund. A good manager would dump certain stocks and embrace others if assumptions about future inflation changed. All stocks do not react the same way to higher interest rates, and no major market features more differentiated behavior among stocks than the United States. If interest rates are set to keep rising, it pays to have a plan of action.
To see why rates matter so much to certain kinds of companies, imagine your household has little or no debt at all. You pay rent on an apartment every month, pay off your credit card in full regularly and take the bus to work. You are saving for some day in the future when you will buy a car or a house, maybe five or eight years down the road. How do interest rates affect you? Probably only inasmuch as higher rates get you a higher return on your savings account.
But if you had a mortgage and car payments tied to movable interest rates, then a major increase in rates would actually hurt you, maybe quite badly, as your mortgage payments increased.
The same goes for companies. Higher interest rates can kill businesses that are heavily leveraged (have a lot of debt), or those that invest heavily in bonds. Insurance companies hold piles of bonds, for instance, because they have so much premium money to invest. Because bond prices move in the opposite direction to rates, higher rates make the insurance company's bonds worth less.
If rates rise, "the kinds of companies that would not be hurt would be those that were not capital-intensive or ones that could have better control of their prices in a rising-interest-rates environment," said Walter Neely, a professor of finance at the Else School of Management in Jackson, Miss., who has studied the relationship between rates and stock prices. Included in this list are "tobacco companies or perhaps consumer companies, as long as they didn't rely on consumer credit." After all, people still have to eat (and plenty have to smoke), no matter what the Federal Reserve does.
Interest rates tend to rise because inflation appears to be around the corner. Because prices of natural resources often contribute to inflation, and the companies that own these assets benefit, investors often flock to oil and mining stocks when rates are headed up, as they have this year.
Conversely, rising rates would hurt "any capital-intensive company, like utilities, banks and real estate companies," said Neely, because they either have to borrow piles of money, or else--in the case of banks and real estate--their customers do. Sure enough, after the Federal Reserve rate rises in June and August of this year, bank and insurance stocks suffered more than other sectors.
Which companies might be decent investments in the event of rising rates? Take a look at Clorox, which makes the bleach of the same name, plus a bunch of other household staples, including Roach Motels and Brita water filters. These are things that households purchase no matter what the interest rate is. Clorox trades at 25 times expected earnings. Normally the sort of stock to do well amid rising rates, it fell 16 percent in a single day last month after it reported higher costs and lower earnings than anticipated for the latest quarter. The culprits: a slower-than-predicted integration of a $2 billion business recently purchased, First Brands, and higher resin prices that go into making First Brands' Glad bags and Clorox bleach bottles.
Nonetheless, analyst James Dormer at Morgan Stanley rates the stock "outperform" and figures it could go from the $44 it was trading at last week to $65 within 12 to 18 months because the market oversold it in a panic. Clorox has been in the news of late, with rumors that it would buy Unilever, or vice versa, but Dormer says the stock is a buy on fundamentals alone. Also attractive is the idea that Clorox has a debt-to-equity ratio of 45 percent, having paid for First Brands with shares, not cash.
Another beaten-up consumer stock worth looking at is bookstore chain Borders Group. It trades at just 13.3 times trailing earnings, with a debt-to-equity ratio of just 0.01 percent--making it, for all intents and purposes, debt-free.
Then there are the classic inflation hedges, mining companies, which have soared over the past year as commodity prices have recovered from inflation-adjusted all-time lows. Two companies worth looking at are South Africa's second-biggest platinum miner, Impa-la Platinum Holdings Ltd. (which trades in New York via an American depositary receipt) and America's only producer of platinum and palladium, Montana's Stillwater Mining Co.
Analyst Mike Wright at Warburg Dillon Read in Johannesburg is typical of many analysts who follow Impala: He loves it, and he figures earnings will rise 30 percent this year. Impala trades at 11 times expected earnings and traditionally has traded at a discount to the sector leader, Anglo American Platinum Corp. Some of the problems facing Impala that caused the discount, such as a disagreement over royalties with South Africa's Bafokeng Nation, have been settled. Other issues, Wright said, appear close to settlement. Impala is now growing much more quickly than Anglo American, has piles of cash and for the past five years has kept current debt flat and reduced long-term debt.
Johan Odendaal at Merrill Lynch also likes Impala, but the stock has run up so quickly this year that he counsels waiting until October to buy, following what traditionally is a slack period on the South African market. In the long term, though, Impala's improved productivity and a probable shortage of platinum (as analysts figure Russia sold most of its stockpiles this year) should make for improved platinum prices in the next several years. So should the move worldwide to increase the use of platinum in automotive fuel cells, he said.
Just last week, Stillwater Mining shook up its management after sluggish second-quarter earnings caused by a fall in productivity. The stock trades at 21 times expected earnings but is down 30 percent since the Fed's first rate rise June 30. Both CIBC and Nesbitt Burns call it a "strong buy."
All of this may be fine strategy, but how likely is it that interest rates are headed higher? First of all, distinguish between short-term rates and long-term rates. The Fed has raised short-term rates twice this year, but these were so well telegraphed that investors had largely factored the changes into prices. Stocks actually rose overall after the rate increases. That is no surprise to Michigan State University finance professor John Gilster, who co-authored a study in 1996 showing that while long-term rate changes mattered to stocks, prices tended to rise no matter whether short-term rates had gone up or down.
"The consensus prior to our paper was that when short-term rates went up, it was bad for stocks. We find that either way it's good for stocks," he said, but when long-term rates rise, "it's lethal."
Ned Riley, chief investment officer of the Private Bank at BankBoston, figures that Greenspan and the Fed no longer have much control over long-term rates. "The bond market today has become so Pavlovian in its response to stronger growth that we have a built-in mechanism to mitigate the cycles that used to be quite violent and sharp," he said, adding that "the bond market has been ahead of the Federal Reserve all year."
Will the bond market decide inflation is due to pick up? What frightens me into thinking that it might is America's near-$300 billion current account deficit. That means that foreigners have been lending the United States a ton of money, and if Japan and Europe begin to pick up economic steam, they could want to take some of their money for investment closer to home. That would mean a big sale of dollars, higher import prices, more inflation and higher interest rates.
The signal the bond market needs could come from within the United States, too. Merrill Lynch chief economist Bruce Steinberg expects that because of the Y2K problem, there will be no more rate increases by the Fed until 2000. But if the bond market starts to anticipate a Fed rate rise in January, stocks won't wait around for all the formalities before falling.
One final bit of advice: Don't assume that because U.S. rates rise, foreign stocks are necessarily a safe place to hide. A new study by Germany's Commerzbank found that stocks in Britain actually react 40 percent more sensitively to rises in U.S. rates than to rates in their own country. The best sectors on the London exchange during U.S. rate rises were steel, forestry and paper, aerospace, chemicals, packaging, and automobiles. The worst stocks during periods of rising U.S. rates were real estate, insurance and water utilities.
Philip Segal is the Hong Kong correspondent for the International Herald Tribune.