The Case for Quality Stocks Now

While conventional wisdom says that rising interest rates are bad for stocks, it’s more accurate to say that rising rates tend to be bad for certain types of stocks. This group includes investments that excel when greed is the overriding emotion driving the market, such as highly leveraged companies with poor balance sheets. But when interest rates are rising and fear becomes the dominant emotion guiding investors, speculative stocks tend to do poorly.

Factors That Outperformed in Past Rate-Hiking Cycles

Source: Furey Research Partners, FactSet and Russell 2000. Chart depicts data from 1987 to 2018 and the quality and quality-related factor that perform well in rate hike periods. Economic predictions are based on estimates and are subject to change. Russell 2000® Index includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

This begs the question: What types of stocks do relatively well in rising rate environments? As the chart above shows, stocks that exhibit “quality” factors have generally outperformed speculative fare in rate-hiking cycles over the past 35 years. For example, high quality stocks — shares of companies sporting strong balance sheets and exhibiting a high return on equity and high-quality earnings — have outperformed low quality stocks in all five Fed rate-hiking cycles since 1987, with a median outperformance of 8.41 percentage points. 

Similarly, shares of companies with low leverage have significantly outpaced highly levered companies during rate-hiking cycles, when the markets tend to be in “risk-off” mode. This would seem to make sense, as high-quality stocks and companies that rely on less debt are close cousins. Both seem to exhibit strong potential margins of safety. 

At Heartland, we favor low-leverage stocks within the small-cap space regardless of the interest rate environment, as one of our core tenants is to avoid combining operational risks with financial risks whenever possible. Of course, you can’t avoid operational risk altogether when investing in stocks — small or large. But you can reduce financial risks by focusing on high quality companies with low debt levels. The good news is that both of those factors have historically performed well, on a relative basis, when the Fed lifts short-term rates to cool the economy and inflation, as it is doing now.