Think of investment sectors as neighbourhoods. If you own the best house in the worst neighbourhood, the market will assign a discount on your home’s value. Own the worst house in the best neighbourhood and you’ll enjoy a premium valuation. That’s how Barometer Capital describes its approach to investing, and investors may want to follow suit, especially if your portfolio lives in the financial district.
“The vast majority of your return comes from being in the right sector,” says Diana Avigdor, vice-president head of trading and portfolio manager at Barometer Capital, a Toronto-based wealth management firm. With interest rates climbing in the U.S. this is an important time for investors to make sure they understand which neighbourhoods they’re in.
The current rise in rates in the U.S. Is more about a normalization, after a lot of intervention to boost the economy. It’s not about an expected surge in inflation. Regardless, investors have a good window to take stock of their portfolios. Avigdor says research shows that the correlation between rate increases and stock markets is positive until the yield on 10-year U.S. Treasuries reaches 5%. Currently the yield is around 2.5% and expected to push towards 3% by the end of the year.
Prospects for different ‘neighbourhoods’ vary. Generally speaking, financial stocks, which include banks and insurance companies, benefit from rising rates. Conversely slower growth companies like real estate investment trusts (REITs), utilities and telecom companies, which are seen as bond proxies because they deliver a steady cash flow to investors, have a tendency to lag as rate climb.
The past 10 years haven’t been ideal for financial stocks. New compliance measures and regulations made it difficult for financial stocks to advance, particularly in the U.S. “For a while they became the new utility where they couldn’t grow,” says Avigdor.
Financial stocks took a sharp turn up when Donald Trump was elected president. Since then conditions for financials have been near perfect. These stocks got a lift when the Republican president started cutting some of the regulations put in place following the financial crisis. These stocks are also benefitting from higher interest rates. Financial stocks make money on their yield margin—the difference between the rate they borrow at and the rate they charge customers—explains Avigdor.
She recommends owning three Canadian and three U.S. financial stocks, which are trading at lower premiums. One standout in the U.S. is Bank of America, which is currently trading at 1x book value. It’s basically trading at liquidation value, she says. It doesn’t have much of a yield—just 1.3%—but it’s attractive as a growth stock. The only reason to avoid this stock is if you expect their loans will deteriorate, which would affect its book value.
REITs may be in the wrong neighbourhood
While financial stocks are flourishing in this environment, REITs are not. Many of these companies currently aren’t offering much in the way of growth, says Avigdor.
Mark Rosen at Accountability Research Corporation, an independent equity research firm, agrees, although he cautions against abandoning any sector outright. “I don’t think it’s ever a great time to say I’m going to play a sector and say I’m going to be in or out based on where I think rates are going.” The selection of good income-generating companies is limited to ignore certain companies, regardless of what sector it’s in.
“You want to be more selective with that REIT you own,” he says. You have to look at the quality of the investment, focusing on the cash flow and growth overall.
“What trumps income overall is expected growth and where that will come from,” he says. With REITs, investors will have to pay closer attention to the sub sectors within this category, looking at the prospects of REITs focused on commercial real estate versus, say, apartments.
If the market is really missing something then that’s the opportunity to outperform by loading up on a particular sector, but Rosen doesn’t believe this is one of those times.