John Dorfman on how five investment sectors are likely to be hurt — or helped — by the current downturn
Last week interest rates on government bonds rose to their highest level in months. The yield on 10-year Treasuries hit 3.99 per cent last Wednesday, the highest since October. The 30-year bond yield rose to 4.77 per cent, the highest in a year. Traders blamed a large US Treasury bond auction and Russia’s threats to sell some of its US debt.
Get used to it. Interest rates are likely to climb more in the next three years as US government spending increases. And Russia isn’t the only nation tiring of US paper. China and other countries voice similar sentiments.
Just like tomatoes or personal computers, government bonds are subject to the normal laws of supply and demand. To sell a lot more of anything, it’s usually necessary to lower the cost.
The price of a bond moves inversely to its yield. To sell more bonds, an issuer can lower the asking price or increase the yield, which amounts to the same thing.
With a budget deficit projected by the White House at $1.25 trillion in fiscal 2010, $929 billion in 2011 and $557 billion in 2012, the US government will be selling more than $2 trillion of bonds in the next few years.
I would be astonished if that doesn’t push up interest rates. Most likely, it will also spark an increase in inflation.
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All this has implications for investment portfolios. Here is my notion of how five investment sectors are likely to be hurt — or helped — by higher rates and increasing inflation.
Utilities get hurt
Utility stocks will suffer. Traditionally, investors buy power-company shares for their dividends. When bond yields are high, utilities usually fall so that their dividend yields are competitive with the interest rate on bonds.
Also, most utility companies are major borrowers themselves. Rising rates increase their cost to borrow money, and may narrow their profits.
I wasn’t a big fan of utilities before the economic crisis, and I’m even less of one now. The weight of utilities in the Standard & Poor’s 500 Index is about 4 per cent. If you have any more than that in your portfolio, I suggest cutting back. The portfolios I manage currently have no utilities.
Technology stocks should escape most of the damage. People don’t buy tech stocks for their dividend yield, so they don’t decline like utilities tend to when rates rise. And most technology companies are not big borrowers. In fact, many are debt-free.
Perot Systems
It’s hard to find ones, though, that are inexpensive enough to meet my value criteria. One I like is Perot Systems Corp, located in Plano, Texas. Founded by former presidential candidate Ross Perot, it takes care of other companies’ information-technology needs. Perot Systems has been profitable in 11 of the past 12 years, and has very little debt (only 13 per cent of equity). The stock sells for 1.3 times book value, 0.6 times revenue and 15 times earnings.
Commodity stocks may be helped, though less by rising rates than by the inflation likely to accompany it. When the government prints more dollars, the price of materials such as steel, copper and gold usually rises as a swollen supply of dollars chases a stable supply of goods.
Pure plays in gold are often too expensive for me. But I like BHP Billiton Ltd, the world’s largest mining company. Based in Melbourne, Australia, BHP Billiton produces coal and oil along with gold and other metals and gets about 20 per cent of its revenue from China. It sells for 11 times earnings.
I’m also fond of Cleveland-based OM Group Inc, the world’s largest cobalt producer, trading at 11 times earnings. And I continue to favour US Steel Corp, one of the cheapest stocks around at three times earnings.
Consumer stock blues
Beware of consumer stocks. Consumers are rebuilding their balance sheets and digging out of debt. It’s a gradual process at best, and rising rates may make it slower, as adjustable-rate mortgages bite harder and refinancing becomes a less-pleasant alternative.
I have earlier said these consumer stocks were overvalued: Amazon.com Inc, Starbucks Corp, Sears Holding Corp and Whole Foods Market Inc. Amazon sells for 57 times earnings and the others trade for more than 23 times earnings. I continue to advise investors to lighten up on these.
Financial stocks would probably be harmed. Banks find it easier to borrow at 3 per cent and lend at 6 per cent than to borrow at 5 per cent and lend at 10. In other words, it’s harder for banks and other lenders to have good lending spreads when interest rates rise.
Stock brokerage firms also suffer when rates go up, partly because they too are involved in lending. Also, when rates rise, bonds pose tougher competition for stocks.
Currently, financial stocks constitute 13 per cent of the S&P 500. I recommend that your portfolio be at that level or less.
Disclosure note: Personally and for clients, I own shares of BHP Billiton, OM Group, Perot Systems and US Steel.