Playing the rates game: Candice de Monts-Petit quizzes IROs on their plans should the Fed raise interest rates in the near future
At a glance IMPENDING HIKE All eyes in the business world are on the US Federal Reserve, which is expected to raise interest rates after six years of high growth. The first rate hike since 2006 will trigger a change in investors’ mind-set, risk appetite and – consequently – asset allocation. RATE SENSITIVITY Raising rates from a near-zero level does not mean an end to the bull market. High-growth companies will be less affected in the short term, depending on their level of debt and strategy for development, while some sectors will benefit from a positive correlation. FINE-TUNED TARGETING IROs should closely monitor what investors will be looking for in a higher-rate environment and adapt their targeting strategy accordingly. Rate-sensitive businesses can ride the cycle by taking a long-term view in managing their balance sheet. |
After several years of high growth in the US and a final stalling in the aftermath of China’s market crash in August, the US Federal Reserve may raise its near-zero interest rate as soon as the end of this year.
The first rate hike in almost a decade is bound to plunge IROs who are new to the profession into a whole new environment, and could see dramatic changes in investors’ mind-sets and preferences. In the light of changing risk appetites and heightened scrutiny over capital structure, investor-targeting strategies will need to be reviewed and fine-tuned. IR teams, particularly those working at businesses deemed rate-sensitive, will have to convince investors that their long-term equity story can see them through the interest rate cycle.
Asked how a rate hike would affect his business, Ray Martz, CFO at Maryland-based property investor Pebblebrook Hotel Trust, appears moderately concerned. ‘We’re a real estate investment trust (REIT), which is a typically interest rates-sensitive vehicle and a slightly different asset class from a straight equity,’ he explains. ‘Because of the income REITs pay out in dividends, investors look at our sector as an alternative to other fixed-income products. Therefore, all things made equal, if interest rates are rising it means it’s more competitive to buy a relatively less-risky government bond today than it was yesterday, and because REITs tend to use more leverage as an overall industry, it will also make your costs significantly higher.’
Pebblebrook, however, holds an advantage thanks to the nature of its investments. ‘Our hotel rooms are rented out every night, so the difference we have in a rising rate environment – or an inflationary one – is that we can adjust our tariffs daily and increase them accordingly,’ Martz says.
This has allowed the company, which invests in hotels in ‘major US gateway cities’, to display yearly growth, both top and bottom line, averaging 25 percent over the last several years. This sustained growth rate gives the company an unusual profile in the REIT space. ‘That's why the rate environment is less of an issue for us right now,' Martz says, highlighting that the real estate sector on the whole tends to grow in the high single digits. The potential risk for the hotel sector is that you have a lot of operating leverage, which is great in a good economic environment but is a double-edged sword during the downside.’
No medical emergency
Alpharetta, Georgia-headquartered MedAssets is a NASDAQ-listed $1.2 bn market cap healthcare technology firm. The firm’s IRO of eight years, Robert Borchert, doesn’t anticipate the upcoming rate rise will have a substantial effect on the company’s targeting or investor communications efforts. ‘Most companies in our sector do not pay dividends or they’re more growth-oriented,’ he says. ‘The potential impact will depend on the size of the company, its current capital structure, how much leverage it is carrying and how much of that debt is fixed rather than floating.’
A company’s long-term strategy – organic growth versus M&A – can also change certain perspectives, while firms that are potential takeover targets may become less attractive as rising rates make a debt purchase more expensive. For rate-sensitive businesses, moreover, Borchert stresses the importance of keeping abreast of what a firm’s current and potential investor base will be looking for. ‘In consumer discretionary markets or financials, for example, the change in focus and challenges you face as an IRO are much more evident,’ he says. ‘You’ll need to be fully cognizant of how investment perspectives might change.’
The financial and consumer sectors are good examples of a beneficial outcome ‘because if rates are slightly higher there’s going to be better returns, from lending as well as profits from the financials. If discretionary spending improves or increases over time, that should help consumer type companies,’ he explains. ‘For most IROs, once they get past Investor Targeting 101 of who owns them versus their direct peers, the success of their outreach will require a deep understanding of not just the mutual fund or advisory firm they’re targeting but also the specific investing criteria of each fund manager.’
Martz reveals that rate talk, while definitely ‘on the radar’, has not been the biggest focus in recent meetings. ‘Investors want to understand our long-term strategy, and the bigger variables for us right now are linked generally to the economic recovery: how the US domestic market is performing – which is good for us – or the strength of the dollar, which for us is a slight negative if it persists, because it makes it more expensive for international tourists to travel here,’ he explains.
The firm provides a yearly outlook with assumptions on interest costs and the economic environment, as well as a three-year view of the perspective. ‘In our IR books we always include our balance sheet, which goes over our debt maturities and current rates, in order to make it easy for investors to understand and ask the right questions,’ Martz points out. ‘We look at the global cycle to try to understand the flow of money and at which stage we are, because that’s how we make long-term investment decisions.’
In the early part of the cycle, the firm will seek to have more fixed-rate financing and will opt for floating rates at a later stage ‘because those will be higher rates and will indicate we may be heading into a recession. What you don’t want is to have a lot of fixed costs in a down cycle,’ Martz stresses, adding that his firm approaches the issue over a five to seven-year perspective. ‘When we decide to take a floating rate or a fixed one, not knowing when the Fed will act can add some uncertainty with that,’ he admits.
The right time
Borchert believes the question of timing is not a significant issue when it comes to general market sentiment. ‘Given that it’s been at least 18 months of the Fed discussing a potential or expected interest rate increase, much of that has already been factored into the market,’ he says, highlighting that the most recent volatility was global instability – and not interest rate- related. ‘If you’re at nil-rate, I think any increase that could offset any potential inflationary or deflationary environment is appropriate, and most of the marketplace has [already] reckoned with that.’
IROs attempting to prevent investors from shifting their holdings should not forget to stress the underlying reason interest rates may be rising and, most importantly, the effect on their business on the medium to long term. ‘One of the primary reasons for the continued discussion about raising interest rates is that the US economic environment has been improving,’ notes Borchert. ‘And an improving economic environment usually means stronger wage growth, higher spending and improved lending activity.’
For that reason, Borchert is keen to remind people that increasing rates from a base of zero does not mean an end to a bull run market, ‘even with this volatility we’ve been seeing. It means you’ve raised rates because you’re actually seeing better times ahead.’
Martz is more curious about the outcome. ‘At the beginning of the year, the newspapers were all saying, This is the year interest rates are going up, and now it certainly feels like it,’ he says. ‘But we felt the same every year of the last five. At some point of time, we know it’s going to happen –it’s not going to stay so low forever – so it will be interesting to see what happens when it does take off.’
US Federal Reserve funds rate since 1954
THE CHALLENGE OF LIVING IN INTERESTING TIMES
Q&A with Dan Romito, senior analyst in targeting & investor analytics, NASDAQ Corporate Solutions
How can an interest rate rise affect a company’s shareholder base?
One of the primary implications that should concern IROs is the downward pressure it will have on valuations. Combined with the current state of the market, this means long-term investors will have to evaluate two critical aspects of their portfolio. First, what is the compelling motivation to remain in the stock? In other words, if the stock has had a nice run, why shouldn’t the portfolio manager begin to take some exposure off the table? Secondly, pressure on growth, along with increased discount rates, place a heavier emphasis on capital allocation strategies. Management teams with longer track records of allocating capital that result in the creation of shareholder wealth will typically get the benefit of doubt in terms of remaining in the stock. Particularly, the manner in which free cash is deployed will be closely monitored. Portfolio managers are typically more inclined to take profits during a market correction with companies that are hesitant to allocate free cash in a manner that optimizes shareholder return, such as growing the dividend or repurchasing shares.
In which sectors will it have the most impact?
Traditionally cyclical sectors face the biggest impact. I anticipate the consumer discretionary, IT, materials and industrials sectors to experience the most volatility and pressure for performance. Throughout the first half of the year, those sectors all maintained a relatively high forward-looking price/earnings-to-growth ratio and dividend yield, so investors were willing to pay a higher premium per unit of growth and yield. Given the macro-environment in the latter half of 2015, we have definitely begun to see that trend reverse. I would also be concerned if a notable percentage of my company’s revenue derived from overseas: with increased discount rates and decreased conversion rates, it just adds additional pressure on valuation.
What tips would you give IROs for effective targeting in a rising rate environment?
Mitigating a rising rate environment is contingent upon:
1. Identifying the shareholders within the company’s top 50 that are most inclined to take profits and analyzing how the investor has managed its portfolio: what does its sells look like and what common denominator do they share from both a fundamental and industry standpoint?
2. Pinpointing the generalist and/or stock picker fund that would remain interested in the company’s stock. It’s always important to extend opportunity by seeking out sector-agnostic investors that are not concerned about the space you operate in, but focus on the specific risk/return profile your company offers. Risk/return, in large part, is a function of the flexibility of balance sheet and management’s corresponding efficiency in allocating capital. Understanding where your company’s fundamental profile parallels with the appetite of the generalist will help broaden tighter pools of capital.
3. Understanding activism and where your company is vulnerable – we are seeing a growing trend where long-term investors are more than willing to turn to an activist in order to at least investigate opportunity. Market corrections place investors in a very sensitive position and if they feel value could be attained under an alternative capital deployment strategy, they are more inclined to reach out to an activist to pick their brains with certain scenarios.
This article appeared in the Winter 2015 issue of IR Magazine