Buyer beware: Rising rates could send low-growth big caps into reverse

Instead all that happened is record high asset prices being achieved – and a great deal of debt accumulated.  In Denmark, where interest rates have been negative for the longest period of time, savings are rising and spending is declining.

Albert Einstein defined insanity thus: doing the same thing over and over again and expecting different results.  Economist Herb Stein observed; if something cannot go on forever it must stop.  Eventually the thirty year-long trend of declining bond rates will end.  When rates start going up, the thirty-year trend of rising asset prices might also change.

Aside from those who have accumulated immense debt investors in the most danger will be those who have been buying and holding the shares of companies with little or no growth.  They have been buying shares for the attractive dividend yield not realising those dividends have been funded by an increased payout ratio.  A higher payout ratio means less profits are being retained for future growth.  In other words, investors have paid record high prices for the shares of companies with less growth.  Another way of looking at is that they have accepted bond-like returns while taking on equity market risk.  History suggests this doesn’t end well.

In a rising interest rate environment the ‘P’ in the P/E ratio falls and the ‘E’ (for earnings) in the P/E ratio must rise to compensate.  If the E doesn’t grow the investor can lose permanent capital.

Meanwhile the companies with wonderful growth prospects have fallen significantly.  Companies like Vita Group (down 45%), Healthscope (down 30%), Altium and Isentia have fallen by high double digits.  By any measure they have crashed.

Investors who are holding high yielding, low growth companies have avoided much of the slump in the small and mid-cap high growth companies experienced in the last two months.  But value has now emerged in those latter names and investors are still looking at the prospect of higher interest rates and low growth in the big cap mediocre companies their portfolios are heavily weighted towards.

While you need to speak to your adviser now might be precisely the right time to consider reducing exposure to companies whose dividends will be no higher in five or ten years time and increasing exposure to companies offering strong growth in profits, cash flow and income.

Contributed by Montgomery Investment Management:  (VIEW LINK)