There are no crystal balls in investing. But if interest rates stay higher for longer and the economy sputters next year, there is one group of stocks that could shine.
They are what Wolfe Research, an independent sell-side research firm, calls “double beats with positive price action.” Companies that qualify not only had higher revenue and earnings than expected for both the second and the third quarters, but their stocks also rose following the reports.
“Our sense is that these companies have an increased chance of outperforming their peers as interest rates turn back up and the economic outlook softens,” the firm said in a research note on Monday. Those with high free-cash-flow yields are especially appealing, chief investment strategist Chris Senyek told Barron’s.
The firm has a cautious outlook over the next six to 12 months. Senyek said inflation will be more persistent than consensus estimates suggest, giving the Federal Reserve reason to keep interest rates higher than investors had expected, and hold them there for longer. The yield on 10-year U.S. government debt will rise above 5% again before year-end, and economic growth will be sluggish, Wolfe expects.
“We ultimately think the impact of higher interest rates and the cumulative impact of Fed rate hikes will cause the U.S. economy to have a hard landing sometime in the first half of next year,” Senyek said in an interview.
Rather than cutting interest rates soon, the Fed is likely to choose a policy of “high and hold,” he said. “Historically, the Fed has cut interest rates six to nine months after the last hike. We think there is a higher threshold this time for them to cut because inflation is going to stay elevated and sticky.”
Although the futures market is pricing in reductions starting in May, it is even possible that the Fed could raise rates again, building on the 11 increases that have taken the bank’s target for the fed-funds rate from near zero to 5.25%-5.50% since March 2022, he said. “If inflation proves to be sticky and the economy proves to be resilient, then the Fed could end up having to hike again sometime next year, but our base case is they’re done for now,” Senyek said.
High rates and slow economic growth are generally trouble for stocks, so Wolfe Research screened
S&P 500
companies for those that could do well nonetheless. It found more than 50: a mix of cyclicals—companies that prosper when the economy takes off and struggle when it falters—and defensives, which are supposed to hold the line even in hard times.
“We tend to favor some sectors over others,” Senyek said of the list of 50-plus stocks. “If we had to pare this screen further, we would lean toward more defensive groups like [consumer] staples, healthcare, and some tech.”
To further narrow down the list, he advised looking for companies with free-cash-flow yields of 4% or more. The metric—a company’s free cash flow divided by its market capitalization—indicates how investors are valuing the company’s cash production. A high free-cash-flow yield usually means a company is in good shape to maintain or increase its dividend or ramp up capital investments.
“We’re in a market environment where cash is king,” Senyek said. “Companies that are generating above-market free-cash-flow yields are likely to do positive things with the cash going forward, whether it’s for higher dividends or buybacks or debt repayments.”
Companies that qualify both in terms of free-cash-flow yields and as “double beats with positive price action” include Procter & Gamble (ticker: PG),
Coca-Cola
Company (KO), and
Clorox
(CLX) in consumer staples;
UnitedHealth Group
(UNH) in healthcare; General Electric (GE) and 3M (MMM) in industrials; and F5 (FFIV) in technology.
One of the Magnificent Seven tech companies—
Amazon.com
(AMZN)—passed the initial stock screen, but its free-cash flow yield is 1%. None of the other six megacaps qualified in either area.
Investors need to look beyond the big seven tech stocks, said Senyek. “We think some of the fundamentals of the big seven are in the early stages of weakening.”
Write to Lauren Foster at lauren.foster@barrons.com
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