- Interest rates are rising and may remain elevated for longer than expected.
- Cash-strapped companies may struggle to attract stock and bond investors.
- Interest expense will increase for companies forced to refinance existing debt.
The Federal Reserve's price stability mandate has it waging War against inflation this year. But, unfortunately, there's little to prove it's winning the battle. Although the central bank's interest rate increases are slowing economic activity, inflation remains stubbornly high, and corporate profits are sinking.
Last week, Fed Chairman, Jerome Powell, said there hadn't been enough progress on inflation to discuss pausing the bank's hawkish policy. He indicated peak interest rates could be higher than anticipated, and higher rates could last longer than forecast.
If rates continue climbing and remain elevated, heavily indebted companies or companies requiring a lot of cash to grow their businesses could struggle. For this reason, knowing if you're overexposed to stocks at risk of a cash crunch is critical.
Climbing costs of capital
Real Money Pro's Bret Jensen recently explained how he's been evaluating stocks in his portfolio, given interest rates' likely path. In "There Is No Escaping the Scourge of Rising Interest Rates," he writes:
“Corporations also are impacted by higher rates, which is one reason in recent months I have done a full review of every stock in my portfolio in recent months. I have purged nearly all my holdings in small-cap biotech, fintech, ad tech, or electric vehicle concerns that are likely to need to raise more capital over the next two years. They either will need to dilute shareholders at lower prices or finance operations via more expensive debt.”
In the recent past, cash-strapped companies had plenty of levers to raise money. Today, their options are limited.
Secondary offerings aren't as attractive because investors aren't willing to accept dilution, and they're demanding lower valuations. Similarly, bond issues require a higher interest rate or dilutive warrants to attract investors. As a result, cash-hungry companies are forced to borrow from banks charging more because of the Fed's interest rate increases. Soon, companies on shaky financial footing may discover banks are unwilling to take on the risk of loaning them any money at all.
Back to Jensen:
“I have also looked at my profitable names that do carry large amounts of debt to ensure that they don't have significant debt maturities they will need to roll over during the next couple years as they will need to do so at higher rates.”
It's not only fledgling companies that are feeling the sting. Over the past few years, money was cheap, so many companies tapped lenders for loans that may begin maturing soon. However, rolling debt over could increase the interest expense line on the income statement, reducing net income because rates have increased significantly this year.
Since refinancing debt could substantially reduce earnings, it is important to know how much debt is owed and when it's maturing. You can find this information in a company's SEC filings, such as its quarterly 10-Q report.
If you own shares in a company with a lot of debt maturing through 2025, consider if the company can cover those maturities with cash on hand. If not, the company may struggle to find lenders willing to refinance its debt, increasing bankruptcy risks.
The Smart Play
Stocks haven't had much competition from bonds for a while, but that's changing this year because of rising interest rates. For instance, the 2-year Treasury note yields 4.73%, a relatively attractive return, given stock market volatility.
Since bonds finally compete with stocks for investment dollars again, there's less reason to own "any stock at any price." This is especially true because corporate profit growth is shrinking due to inflation and slowing economic activity.
According to FactSet, S&P 500 earnings per share growth is tracking at just 2.2% in the third quarter, the lowest increase since Q3, 2020. The consensus estimate is for fourth-quarter earnings to fall 1% year over year, down from 3.9% on September 30th and 9.1% on June 30th. Over the weekend, Goldman Sachs reduced its outlook to 0% earnings growth in 2023, suggesting more challenges ahead.
The financially strongest companies should have the best opportunity to withstand higher rates pinch, so consider creating a spreadsheet to track key line items on the balance sheet and income statement. For example, evaluating trends in cash and equivalents, short-term debt expiring in one year or less, long-term debt, and interest expense can help gauge whether a company in your portfolio is healthy.
However, remember that since that data is backward-looking, you'll also need to know the debt maturity schedule so you don't get surprised by a profit-busting spike in interest expense.
One final tip: Watch the current ratio for clues. The current ratio measures a company's ability to pay short-term liabilities with short-term assets. A ratio above 1 is positive, while a ratio below 1 suggests more due diligence is necessary.