Nine Underleveraged Turnarounds
George Putnam, The Turnaround Letter 05.08.06, 2:00 PM ET
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It seems like everyone is worried about interest rates these days. Not that that's anything new. Everyone's been worried about interest rates since before the Federal Reserve started its current string of rate hikes in June 2004. We even wrote an article about rising interest rates back in the March 2004 issue. Come to think about it, investors are always worrying about interest rates.
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Rather than worry about them, should you actually do something now because of what is happening (or expected to happen) with interest rates? Our answer today is basically the same as it was in March 2004, when we wrote, "Notwithstanding our view that rates will rise, we do not recommend taking major action."
Our position on rates has changed--we don't have a clue where they are going from here--but our advice is the same. As we have said before, you should not try to time the stock market for any reason, and that is especially true with respect to interest-rate forecasts. Most of those forecasts are wrong. And even when investors correctly predict how rates will move, the stock market often reacts to the rate move differently than they expect.
For example, stocks are generally expected to fall when interest rates rise. There is even an old adage, known as the "three steps and stumble rule," which says that the market will fall whenever the Fed raises rates three times in succession. Well, the Fed has raised rates 15 consecutive times since June 2004, and the Standard & Poor's 500 is up 18% over the same period.
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While we don't recommend making any major changes in your portfolio based on interest rates, we do have a couple of suggestions that may cause you to do a little tuning.
Our first suggestion is to avoid the stocks of companies with heavy debt loads. Many of these stocks have soared over the last few years because, with low interest rates and a strong economy, the financial leverage has worked to the companies' favor.
But leverage is a two-edged sword, and in many cases we expect it to soon begin to cut the other way. With interest rates at their highest levels in several years, the cost of carrying debt has become more onerous. Many of these leveraged companies are also facing higher energy costs and higher raw materials costs. Some of them are likely to default on their debt even if the economy remains strong. If the economy falters, we could see a torrent of defaults.
Our second suggestion is to avoid most of the homebuilding and mortgage stocks. These two industries have thrived over the last few years, as low interest rates and a strong economy have spurred demand for new houses financed with cheap mortgages.
As a result, many of the stocks in these sectors may look attractive today because they are trading at low price-to-earnings ratios and have generous dividend yields. However, if interest rates stay where they are or go higher, things will not look so rosy in the future.
We are particularly concerned about the mortgage-related stocks. Some mortgage lenders have boosted demand in recent years with creative new products that offer very low rates for a year or two before reverting to market-level interest rates. Many consumers may have been lured by these new products into taking out larger mortgages than they can really afford.
They now face a double whammy of the expiration of the low initial rates plus market rates being at higher levels. This should lead to rising mortgage delinquencies and defaults in coming quarters, which will hurt the mortgage stocks.
As we pondered the risks in highly leveraged stocks, it prompted us to think about companies at the other end of the debt spectrum. If we are indeed headed into a period characterized by high interest rates, high energy and raw materials costs and a softening economy, stocks of companies with little debt may provide some welcome stability.
Given our contrarian bent, we looked for low-debt companies that could be involved in a turnaround and whose stocks are well below their long-term highs or have otherwise not participated in the recent market strength. If these stocks do begin to rebound, they will contribute significant returns as well as stability in a challenging environment. The stocks highlighted in the accompanying slide show come from a diverse group of industries and cover a wide range of market capitalization.
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