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How
to Gauge Interest Rate Risk.
It
appears that investors are becoming more optimistic and many are
contemplating putting money back into the market in the expectation that
the economy will pick up once we have the war behind us.
Hopefully
that optimistic view will come to pass and investors will finally have
something to cheer about. If it does, however, we have to consider a
possible side effect of an improving economy: rising interest rates.
Interest
rates are currently at historic lows, but experts tell us that rates are
likely to increase once the economy is clearly on the mend. Here are
three factors to consider that will help you evaluate the risk of your
stocks being impacted by the increasing rates, should they come to pass.
1)
Industry Susceptibility
2)
High Debt
3)
Financial Health
You
can research much of the information on a variety of sites, but
everything you need is available on Morningstar’s free Snapshot
report, and I’ll use that to demonstrate the analysis.
Get
to the Snapshot report by getting a price quote on Morningstar’s
homepage (www.morningstar.com)
and then selecting Company
Snapshot from the Snapshot dropdown menu.
Industry
Susceptibility
The industries most affected by increasing interest rates are those that
sell big-ticket items requiring consumers to borrow to purchase their
products.
Take
home sales for example. The vast majority of homes are bought on credit.
Rising interest rates will increase payments, which in turn will make
homes less affordable. Consequently, it’s likely that homebuilders
will report disappointing results in the coming months. Slowing home
sales will also hurt related industries such as mortgage lenders as well
as the furniture industry, hardware stores, and other sectors that
derive a significant portion of their business from homebuyers.
The
automobile industry is also likely to suffer for the same reasons, and
I’m sure that you can think of others.
Banks
and other financial institutions can also be impacted by increasing
rates because their costs of funds increase. Also, share prices of
utilities and other dividend paying stocks may come under pressure
because their dividend yields are no longer as attractive compared to
alternatives such as money market funds.
If
you’re not sure exactly what the company you’re researching does,
start by reviewing Morningstar’s description of the company’s
business, which can be found in the Operations section near the bottom
of the Snapshot report.
High
Debt
Working with borrowed money is not necessarily a bad thing if a firm can
use the funds productively. Nevertheless, rising interest rates will
impact big borrowers because it will cost them more to service their
debt. The increased costs will reduce their earnings.
You
can identify high debt firms by checking the financial leverage ratio in
the Profitability section of Morningstar’s Snapshot report. Financial
leverage is defined as total assets divided by shareholders’ equity. A
company with no debt would have a financial leverage ratio of one, and
the higher the ratio, the more debt.
The
average leverage ratio of all companies making up the S&P 500 Index
is 5.0. Intel and Microsoft are examples of low debt companies with
leverage ratios of 1.2 and 1.3, respectively. Kellogg Company and
Colgate-Palmolive exemplify very high debtors with ratios of 9.6 and
13.7 respectively. As a rule of thumb, consider ratios above 5 as
high-debt. Obviously, the lower the ratio, the less the susceptible a
firm is to rising interest rates.
Financial
Health
Rising interest rates will likely further weaken firms with already
wobbly balance sheets. You can check Morningstar’s take on a
company’s financial health by viewing its Financial Health grade
listed in the Key Stats section of the Snapshot report.
The
computer-generated grades run from A to F, where A is best. Grades D and
F reflect excessive risk, which you don’t need in this environment. To
be on the safe side, stick with stocks graded C+ or higher.
Predicting
the direction of future interest rate changes is a difficult game.
Experts have been predicting that interest rates would soon rise for
more than a year, but the unexpectedly weak economy drove rates down
instead of up.
Even
so, the precautions I’ve advised, concentrating on low-debt stocks
with strong balance sheets, can’t hurt, even if interest rates remain
low.
published 4/6/03 &
4/13/03 |
