Five stocks to hold in a rising interest rate environment

Foresters Asset Management's Suzann Pennington picks two energy stocks, two banks and one healthcare company.

Ruth Saldanha 29 October, 2018 | 5:00PM

The Bank of Canada last week raised its benchmark interest rate by another 25 basis points to 1.75%, broadly in line with market expectations. The rate hike is the fifth since the bank began raising rates in 2017.

"Governing Council agrees that the policy interest rate will need to rise to a neutral stance to achieve the inflation target," policy makers led by Bank of Canada Governor Stephen Poloz said.

"To achieve its target neutral rate implies the BoC is targeting at least three more quarter-point rate hikes," said Suzann Pennington, chief investment officer for Foresters Asset Management, which oversees a suite of mutual funds under the imaxx brand. She notes that as rates move to neutral, stock valuations become even more important and investors shift to visibility of earnings, which typically results in market volatility as markets adjust and question earnings forecasts.

What does this mean for stocks in the immediate term?

"Interest rate increases are important, but as long as earnings are expanding, stock prices can move higher," Pennington said. Among key recent concerns, she cites the impact of a tight labour market, low productivity, rising transportation costs and especially tariffs and trade conflicts on corporate earnings, which have impacted the earnings visibility required in rising rate environments and created additional headwinds for markets.

This can be seen in the S&P/TSX Composite Index performance. The index is almost flat since July 2017, when the Bank of Canada started raising rates. It is down 3.5% year to date, and down 0.7% over 12 months.

"The S&P/TSX Composite is little-changed since the BoC began raising rates, while corporate profits have increased at a double-digit pace, resulting in the Canadian market price-earnings ratio declining to only 13 times 2019 projected earnings -- close to a five-year low," Pennington notes.

So where can investors find value right now?

The Foresters team has a three-point focus, Pennington said, the first of which is high-quality companies, the second is companies with strong balance sheets wary of rising debt costs and self-funding business models, and companies that are able to grow dividends.

From these parameters, Foresters recommends five ideas for investors to hold for the medium term, two of which are in the energy sector.

"We have been cautious on Canadian energy producers as there is insufficient pipeline capacity to carry production from Western Canada to refineries. This is forcing increasing amounts of oil onto rail and tanker trucks. This has resulted in Canadian oil prices trading at their greatest discount in history relative to both U.S. (West Texas Intermediate) and international (Brent) oil prices. The net result is that, despite global oil prices nearly tripling from their 2016 lows, Canadian heavy oil prices are barely above their 2016 lows. With no clear indication that this situation will be resolved any time soon, we have chosen to focus our energy investments on refiners, storage and transportation-related companies," Pennington says. The two picks in the space are U.S.-based  Marathon Petroleum (MPC) and Canadian Shawcor (SCL), which both feature in the portfolio of imaxx Equity Growth and imaxx Canadian Dividend Plus.

MPC recently merged with Andeavor, an independent refining and marketing company. The merged company’s business mix is balanced across refining, retail distribution and midstream operations.

"The stock trades at a substantial discount to our estimate of fair value and does not reflect potential synergies and economies of scale to be realized as the operations are merged. Some of Marathon’s refining operations process heavy oil so are benefitting from the current large discounts on input prices. Marathon is likely to benefit from changes in marine transportation fuel regulations which set lower sulphur emissions standards," Pennington said.

Meanwhile, SCL provides products and services for the pipeline industry including specialty coatings, inspection and repair services. The company is a global leader in technology for complex pipe requirements.

"The stock is near eight-year lows, with a price-to-sales ratio of 1.1 times. The current cashflows are supported by sustainable repeatable operations," Pennington said.

The next two ideas are Canadian Banks.

"Canadian banks are trading at attractive valuations. Net interest margins are benefitting from the increase in interest rates and in the shorter-duration portion of yield curve. Moreover, the banks have excellent credit quality and capital levels," Pennington noted.

She points out that though the high household debt levels in Canada might be seen as a risk, with a high portion of bank mortgages insured and low loan-to-value ratios, a normal housing market decline would have a modest impact unless accompanied by a significant downturn in employment levels.

Her top picks in the sector -- and the top two holdings in imaxx Equity Growth -- are  Toronto-Dominion Bank (TD) and  Royal Bank of Canada (RY), which she believes are very high-quality holdings trading at reasonable valuations.

"The current weakness in the market could result in further short-term downside, but with a two- to five-year time horizon, both of these stocks represent core positions," she said.

The final pick is U.S.-based healthcare provider  CVS Health Corp. (CVS). CVS has vertically integrated one of the largest retail pharmacy chains in the United States with one of the largest pharmacy benefit managers. This combination makes it one of the premier healthcare firms in the United States. It has plans to merge with U.S. health insurer Aetna.

"We believe the integrated business model of these two companies will be beneficial under new pharma regulations. Its valuation is close to 10-year lows with a price-earnings multiple below 10 times, a price-earnings-growth ratio under 1 and dividend yield of 2.8%," Pennington said.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
CVS Health Corp64.30 USD1.05
Marathon Petroleum Corp55.10 USD2.19
Royal Bank of Canada107.96 CAD1.00
Shawcor Ltd Class A16.26 CAD-0.25
The Toronto-Dominion Bank76.58 CAD0.37

About Author

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca