UK Inflation is well above its target, so interest rates have risen and probably will keep rising. Yet I am still in the market for UK stocks to add to my Stocks and Shares ISA. There is no harm in looking for stocks that offer better performance now, so long as I am happy to stay invested in them for the long term. Higher rates squeeze consumers’ budgets. That means most businesses get less revenue as demand for their goods and services dries up. So my first thought is to look for stocks that won’t suffer as much in this regard.
Consumer defensive and healthcare stocks
Companies selling consumer staples like food, beverages, and household and personal care products should not take as significant a hit to their revenues as those selling fridges, TVs, and cars when inflation and interest rates are rising. An example of a consumer defensive (or staples) stock is Reckitt. Now, there is nothing to say that Reckitt’s price won’t go down as interest rates rise. But I expect its price to be less volatile than consumer-sensitive (or cyclical) stocks that sell white goods.
Consumer healthcare companies like Haleon, which sell, for example, toothpaste, indigestion remedies, and painkillers, tend to enjoy relatively stable revenues in times like these. Pharmaceutical giants like AstraZeneca might also perform better than more sensitive stocks when interest rates are on the rise.
Value over growth
Companies that are growing fast might need to invest a lot. In a rising interest rate environment, capital expenditures become more costly. Growth companies, therefore, might find it hard to sustain the very thing that underpins their valuations: rapid expansion. There is another problem for growth companies. Since most of their earnings are in the future, they are discounted to today for valuation purposes. Higher interest rates mean higher discount rates and lower valuations.
Value stocks tend to perform better than growth stocks in higher interest-rate environments. They tend to be established companies making big money today and hence are not hit by discounting and increased borrowing costs quite as hard. They also tend to pay dividends more reliably. There are, of course, exceptions, but I am looking for value stocks over growth stocks right now.
Interest rate rise beneficiaries
Some companies might benefit from interest rate rises. Banks can increase their net income margins — the difference between what they lend and borrow at — and improve their profitability. Of course, profitability might fall if the bank’s customers stop taking loans and defaulting and missing payments, even as interest rates rise.
Insurance companies hold a lot of bonds to back the insurance policies they write. If the yield on these bonds increases, the company gets greater cashflows from them. The insurer’s profitability should improve, assuming that claims do not also rise.
But I can’t pick a bank or insurer at random. Nor will just piling into value stocks or any of the stocks mentioned work just because rates are rising. I would have to research any company thoroughly to make sure it makes sense to invest now and for the long term. But, at least, I have narrowed down the number of UK stocks to look at for a rising interest rate environment.
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James McCombie has positions in Haleon plc and Reckitt plc. The Motley Fool UK has recommended Haleon plc and Reckitt plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2022