Which Companies Are Best Positioned for Rising Rates?
Given the U.S. Federal Reserve’s (Fed) current policy of monetary tightening, it is important to consider what types of companies are best positioned to successfully navigate a rising rate environment. In times like these, the stocks of companies with high return on invested capital (ROIC) have historically delivered excess relative returns. We believe that investing in these companies, particularly at dislocated valuations, presents a compelling risk/reward opportunity.
Policy Rate Backdrop
After an extended period of exceptionally easy monetary conditions, the Fed and many of its global counterparts have been raising interest rates to rein in excessive inflation. Their goal is to increase the cost of credit thereby cooling demand, which is outstripping supply. The ability of central bankers to tame elevated prices without pushing the economy into a recession will be a challenge, particularly given heightened geopolitical tensions. For the stock market, this issue is of serious concern to us.
Exhibit 1: Inflation Has Recently Reached 40-Year High while Fed Funds Rate Has Increased Meaningfully
Sources: FactSet, U.S. Department of Labor, Federal Reserve. Data from December 1970 to April 2023.
Why We Think ROIC Matters
Companies with high ROIC are well positioned to navigate this economic and market regime due to several key characteristics that we have identified:
- These organizations often maintain strong competitive advantages with efficient cost structures, thereby enabling them to consistently generate economic value even as the cost of capital is rising.
- They typically participate in market sectors with favorable characteristics during periods of rising interest rates and benefit from significant barriers to entry.
- In our experience, organizations that have demonstrated a sustained level of high ROIC are frequently led by leadership teams who understand the core competencies of their respective organizations, have a disciplined approach to capital allocation and take a longer-term view on shareholder value creation. In addition, an ROIC focus at the executive level is often reinforced through proper governance and incentive systems.
During periods of monetary tightening, rising interest rates effectively raise a company’s hurdle rate for both internal projects and external mergers and acquisitions. When lower ROIC peers are struggling to identify attractive investment opportunities given the higher cost of capital, best-in-class ROIC companies can still extract value through strategic capital deployment and re-investment. These allocation decisions can lead to increased market share despite moderating economic growth.
The Return Advantage of High ROIC
The stocks of high ROIC companies have often delivered excess relative returns during historical periods of monetary tightening. The table below highlights how companies with high ROIC levels have performed in the last six Fed rate hike cycles.
High ROIC names (as defined by the top quartile of securities within the Russell 3000® Index) have generated alpha relative to the Russell 3000 in five of these cycles. In the current tightening cycle (through March 2023), high ROIC names have similarly outperformed.
While acknowledging history may not repeat—and that each of these cycles wielded its own unique set of circumstances—the relationship between this quality characteristic and returns may prove informative.
Exhibit 2: Performance of High ROIC Companies during Periods of Monetary Tightening
| Period | Dec '86 - Feb '89 | Feb '94 - Feb '95 | June '99 - May '00 | June '04 - June '06 | Dec '15 - Dec '18 | Mar '22 - Mar '23 |
|---|---|---|---|---|---|---|
| Russell 3000 return | 21.91 | -0.60 | 11.64 | 18.97 | 29.60 | -4.96 |
| Top ROIC Quartile Return | 21.96 | 4.32 | 16.46 | 15.17 | 35.23 | -1.80 |
| Fed Funds Rate Change | 3.50 | 3.00 | 1.75 | 4.25 | 2.25 | 4.75 |
| Starting Fed Funds Rate | 5.88 | 3.00 | 4.75 | 1.00 | 0.25 | 0.25 |
| Ending Fed Funds Rate | 9.38 | 6.00 | 6.50 | 5.25 | 2.50 | 5.00 |
| Rate Hikes | 17.00 | 7.00 | 6.00 | 17.00 | 9.00 | 9.00 |
| Length of Cycle - # Months | 26.00 | 11.00 | 10.00 | 24.00 | 36.00 | 12.00 |
Sources: FactSet, Russell, Federal Reserve. Past performance does not guarantee future performance. It is not possible to invest directly in an index. Indexes are unmanaged and do not incur fees and expenses.
ROIC Opportunity Set
We saw that the accommodative rate environment observed through 2021 caused investors to seek out riskier and more speculative investments to generate returns. As a result, less mature companies—those with inherent risks, such as unproven business models or minimal to no earnings—were able to attract capital and issue equity. This cash-burning subset of the market has increased in recent years—currently more than 750 Russell 3000 constituents do not produce positive returns, as shown in Exhibit 3. While we think a portion of these newly formed organizations will develop into truly disruptive and profitable companies, many will not. From our experience, we’ve see that rising interest rates can have compounding effects on these companies’ sentiment (declining risk tolerance), capital structures (increasing financing costs) and valuations (lowering the present value of future cash flows).
Exhibit 3: Distribution of Returns on Capital of Russell 3000 Constituents
Sources: FactSet, Russell. Data as of 3/31/23. Past performance does not guarantee future performance. It is not possible to invest directly in an index. Indexes are unmanaged and do not incur fees and expenses.
CI SBH ROIC Focus
The team at CI Segall Bryant & Hamill (SBH) implements a bottom-up, fundamental research approach to evaluate and understand the return profile of potential investments. This involves thoroughly analyzing the financial health of current/prospective companies and regularly interacting with management teams to assess their capacity for sustaining or improving ROIC.
By focusing on high ROIC, we believe we are aligning our clients’ capital with quality organizations that may be best equipped to navigate volatile economic conditions—conditions that can be catalyzed by means of a monetary policy shift. Additionally, we believe those companies with strong balance sheets, resilient free cash flows, thoughtful capital allocation practices, experienced executive ranks and leading ROIC profiles are situated to generate value over the duration of market cycles while simultaneously providing downside protection. Buying securities that demonstrate this set of characteristics, particularly at dislocated valuations, might present a compelling risk/reward opportunity in an uncertain market environment such as the one in which we find ourselves today.
Last updated April 2023.
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