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High returns in a low-interest-rate world; 5 keys
If the Federal Reserve is right, and rates stay low for a long time, the implications for investors are huge. Here are five rules to follow when picking stocks now.
By Jim Jubak
Take the Federal Reserve at its word. Whether it cuts interest rates again on June 25 or leaves the Fed Funds rate at its current 1.25%, Alan Greenspan and company have promised low interest rates for as long as it takes. With Europe on the verge of recession, Japan still unable to end its embrace of deflation, U.S unemployment at 6.1% and capacity utilization at manufacturing companies hitting a new low for this cycle in April of 72.5%, as long as it takes could take quite a while.
So investors ought to invest as if low interest rates will be around for a good while.
Now if youre a homeowner, its clear what that means: Refinance and refinance again until youve wrung every last point out of the interest rate you pay on your mortgage, and fix that rate in concrete for the life of your mortgage.
But what does it mean to be a low-interest-rate investor? I think its time to go beyond the conventional generality that low interest rates are good for the stock market and come up with some specific pros and cons for an environment that well all have to live with as long as it takes.
What to look for
Heres my first cut at what to look for in this low-interest-rate environment. Seek companies:- that face as little pricing pressure from excess capacity at competitors as possible
- with strong balance sheets that can raise capital cheaply
- that have lots of opportunities to put that cheap capital to work
- whose new projects earn returns as high as possible over the cost of the new capital that funds them
- whose new projects show returns that are not significantly lower than those for the companys existing businessesIn this column, Ill explain in detail what each of those five rules for low-interest-rate investing means. And Ill give you one pick at the end of this column of a stock that fills that bill.
In my next column, on June 17, Ill build a screen to look for more stocks with the same profile.
And finally, in my piece for CNBCs Business Center next Wednesday night, June 18, at 5:45 p.m. ET, Ill tell you why I think these rules apply particularly well right now to the natural resources sector. (Youll be able to find a transcript of that TV spot on this site on June 19.)
Lets start by getting rid of that current bit of conventional wisdom: Low interest rates are not good for all stocks, as many investors seem to believe right now.
Yes, low interest rates do make stock valuations look cheaper, and that does tend to push up stock prices. But theres no such thing as a free lunch in the financial markets, so, what do you know, low interest rates also work to depress earnings at many companies. Especially in an economy like this one.
Self-defeating policy
In one of his investment letters recently, Richard Bernstein, Merrill Lynchs chief market strategist, pointed out that the Federal Reserves low-interest-rate policy was actually keeping alive the very excess capacity thats at the root of current deflationary pricing pressures. By making money cheap and plentiful, Bernstein argued, the Fed was making it possible for cash-strapped marginal competitors to stay in the game rather than go out of business. A company that is marginally profitable and heavily in debt can, in this environment, refinance its debt, reduce its costs and keep churning out memory chips or airline tickets or long-distance service or whatever.
Of course, this refinancing patch job doesnt really fix anything in the long run. It simply prolongs the death throes of some very inefficient and badly run companies. Refinancing debt at a lower cost doesnt improve the product, strip costs out of manufacturing or bring new customers in the door.
But it does keep the pressure on prices. In industries with excess capacity, any competitor that doesnt go out of business, thanks to refinancing debt at a lower interest rate, is still around to pump out product and compete for customers -- and put more downward pressure on prices.
The airline example
You can see it in the airline industry right now in the pricing pressure being applied by two big airlines, one in bankruptcy and the other skating on the edge. The United Airlines unit of UAL Corp. (UALAQ, news, msgs) and the American Airlines unit of AMR Corp. (AMR, news, msgs) slashed fares to the bone and then slashed them some more. Fly three round trips on United Airlines and you get a free ticket. American Airlines recently offered a roundtrip ticket between Las Vegas and Boston for $249. Thats roughly $60 less than the cheapest roundtrip fare I found on JetBlue Airways (JBLU, news, msgs), an airline with much lower costs than American even after recent worker concessions at American. Think about the pricing pressure thats putting on competitors such as Delta Air Lines (DAL, news, msgs) and Continental Airlines (CAL, news, msgs) that have higher costs than JetBlue.
Hence my first rule for low-interest-rate investing: Avoid industries with huge excess capacity where cheap money, thanks to the Federal Reserve, is keeping marginal competitors alive and price competition fierce.
OK, if thats what an investor should avoid, what should an investor look for?
In a low-interest-rate environment, its all about spread, the difference between what a company pays for its capital and what it earns from deploying that capital in its business. As Ive just explained, this economy will remain a tough place to make a profit, so it helps if a company starts off with as low a cost of capital as possible. Risky companies may be able to raise money thanks to low rates, but they arent raising money at 1.25%. For instance, Texas Industries (TXI, news, msgs), the cement and steel maker, recently sold bonds priced to yield 10.75%. Contrast that to the AAA-rated Berkshire Hathaway (BRK.B, news, msgs), where the cost of capital in 2002 came to just about 1%. In the first quarter of 2003, the companys cost of capital fell to zero.
Cheap capital
Now which company, Texas Industries or Berkshire Hathaway, is going to have an easier job making a profit on its cash? Rule No. 2 says that in this environment you should look for companies closer to the Berkshire Hathaway end of the cost-of-capital scale.
But Rule No. 3 reminds investors that cheap capital isnt an end in itself. The goal is to invest it.
Not every company has equal access to new investment opportunities. Some companies are in mature and contracting industries. Think what it means about the software industry if we take Oracle (ORCL, news, msgs) CEO Larry Ellison at his word and believe that the best use he can find for $5.1 billion of his companys cash is to buy competitor PeopleSoft (PSFT, news, msgs) for its customer list and then shut down that companys product line.
But, remember Rule No. 4, which says a company is looking for not just any investment opportunity but one that generates a return on capital thats higher than the companys cost of capital.
In some industries, that kind of business opportunity seems rare to non-existent right now. A seller of long-distance residential phone service such as AT&T (T, news, msgs) faces such relentless pricing pressure in its own industry that it cant hope for stellar returns on invested capital from investing in the business that it knows best. The average five-year return on capital at AT&T is just 1.9%.
Automakers face similar problems in their industry. General Motors (GM, news, msgs) earned just a 1.8% average return on capital over the last five years and in the most recent year that sank to just 1.4%.
On the other hand, a company like video game retailer GameStop (GME, news, msgs), which is still expanding by building new stores and still grabbing market share in its industry, shows a recent return on capital of 9.5%. The company simply has more opportunities for putting its capital to work at a profit than General Motors or AT&T.
But making a profit on newly invested capital isnt a sole hurdle. Hence Rule No. 5: Look for companies that are making a rate of return on newly invested capital thats at least roughly equal to the returns delivered by past investments.
The Microsoft problem
Call this the Microsoft (MSFT, news, msgs) or Intel (INTC, news, msgs) problem. When a company has a history of making a return of 20% on invested capital, as Microsoft does, then the most recent return on capital of 16.5% seems low. (Microsoft publishes MSN Money.) Even though most companies would kill to earn that return. Same at Intel, where the five-year return on capital is a huge 16.8%, but the most recent annual return is 8.5%.
Do you know of many businesses where a CEO can hope to earn 20% or 16.8% on capital? Thats the worry facing an investor looking at the long-term earnings growth at companies such as these. If new opportunities for putting cash to work will earn lower returns than the companys existing business, investors have to think twice about paying historically high price-to-earnings ratios for these stocks.
Ideally, what you want in this environment is a company with a record of finding solid new business opportunities that offer returns well above the companys cost of capital. But for future stock price appreciation, that record shouldnt set the bar so high that new investments are likely to fall far short of past returns.
One company that comes to mind is Berkshire Hathaway. The companys five-year average annual return on invested capital is 4%, but in the most recent annual period, return on capital has climbed to 6%. Thats a low historical benchmark to beat, and recent returns are certainly moving in the right direction.
So with this column, Im adding Berkshire Hathaway as my first low-interest-rate investing Jubaks Pick. (But Im buying the class B shares; the class A shares sell for $72,400 each. The B shares go for $2,415.)
In my next column, as noted earlier, Ill build a screen to look for other stocks that might measure up.
Update to Jubak's Picks
Buy Berkshire Hathaway B (BRK.B)
The winners in a low-interest-rate environment are companies with the lowest cost of capital and the best opportunities for investing that capital. Everyone knows about Berkshire Hathaway CEO Warren Buffetts ability to find undervalued assets and buy them on the most advantageous terms. (And then find the best managers to run these assets.) But the insurance businesses at the core of Berkshire Hathaway mean that the company can bring in huge amounts of cash from policyholders at a very low cost. Buffett recently estimated that the companys cost of capital was effectively zero in the most recent quarter. And with the float from the insurance business (thats the money the company has available to invest while waiting for claims from policy holders to come due) running at $48 billion recently, Berkshire Hathaway seems to be in the sweet spot of its cycle. As of June 13, Im adding it to Jubaks Picks with a target price of $2,850 by March 2004. (Full disclosure: I will be starting a personal position in Berkshire Hathaway three days after this column is posted.).
Update to previous column
A 10% gain in stocks from here? Sure, but
The fall in the U.S. dollar is about 70% over, Morgan Stanley argued in a June 12 research report. Thanks to dollar buying by the Bank of Japan intended to keep the dollar from falling too steeply against the yen and thus crushing Japanese exports, the dollar remains overvalued even after falling about 18% since the beginning of 2002. In late 2001, Morgan Stanley had been calling for a 20%-25% drop in the value of the U.S. dollar. The last leg of the dollars decline, Morgan Stanley said, is likely to come in drops against the value of the currencies of emerging countries in regions such as Latin America. Thats because Japanese intervention in the financial markets has had the effect of creating an overvalued yen and Euro. And that is now sending investors looking for yield and currency appreciation to emerging markets. The likely result will be a continued decline in the U.S. dollar combined with a retreat in the value of the Euro that will limit damage to exports from the Euro zone.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: GameStop and Microsoft. He does not own short positions in any stock mentioned in this column.
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