Inflation and interest rates are negatively correlated, meaning when one goes up, the other goes down and vice versa. Interest rates are frequently referenced in the RBI monetary policy in order to tame inflation. Tinkering of interest rates (either moving up or down) affects stock prices of a bunch of stocks on the stock exchange. These stocks are collectively known as interest rate sensitive stocks and you might have heard analysts quoting them on business channel a number of times.
As common stock market investors, we too can catch the stock price movements in order to make our portfolio loss proof. In this article we will be discussing a strategy which will help you choose great stocks in the case of high interest rate scenario (In layman term meaning of high interest rate scenario is, you get more returns on savings and fixed deposits, i.e., when you are getting a return of 9% to 10% on your fixed deposits in the bank).
Before we start
Let’s try to understand why some stocks do not perform well in the high interest rate scenario. The figure below explains the situation very clearly. The companies which operate with high debt on their books has to shell out more on paying their interests (higher interest expense) resulting in lower profit. On similar ground they hesitate to borrow more for expansion (lower capital expenditure) further lowering the profit. Consumer buying power and choices too affect the profitability of some interest rate sensitive companies whose products are costly and require borrowing for making purchases. Examples of such companies are auto and capital goods companies where consumers hesitate to purchase when the interest rates are high. Now, as the profits get lower for such companies, in high interest rate scenario their stock prices underperform the broader market.
Before devising the strategy, it’s important to understand how the interest rate scenario will be for the next one to two years. Do not worry as it is not too hard to figure out. Just listen to the RBI governors address on the policy announcement date, or read some good policy post mortem reports on web sites like www.moneycontrol.com or www.economictimes.com. While reading the report, just be careful about the credentials of the author. Once you have a fair idea about the interest rate scenario (meaning it will remain on the higher side or lower side for next one year or so), you can plan the investments. As we are discussing the higher interest rate scenario, let’s assume that the interest rate will remain on the higher side for the next one year.
- Choose companies with low debt – Low debt means low interest out go hence higher profit. Higher profit means higher capital expenditure leading to even higher profit and ultimately higher stock prices. This is the simplest and most profitable strategy to follow. The information about debt is very easy to find out. You just need to have a look at the Debt to Equity ratio of stock of your choice on financial portals.
- Choose the stocks with high FII holding – FII money is considered smart money and they always have more information than common investors. If you see FII’s are increasing stake in some company post the announcement, it’s worth having a look. FII’s do understand the interest rate play very well as they do not have much flexibility on investment in the debt market in India. There is no upper limit on investment in stocks as compared to debt (even in a higher interest rate scenario) for FII, hence they prefer stocks that will perform better in the higher interest rate scenario.
- Avoid companies whose products require leveraged buying – Companies whose product needs leveraged buying by end users are not a good choice as consumers will defer their decision due to higher interest rates. Companies related to Auto, Real Estate and Capital goods fall into this category and should be avoided in high interest rate scenario.
We have intentionally not provided names of any company as the data keeps on changing for them on a daily basis. The information about companies Debt to Equity ratio and FII holding can be easily accessed at websites like www.moneycontrol.com or www.economictimes.com.