"What do we do if interest rates go up?"

Greg Dean's picture

Those of you who are longstanding followers of Cambridge undoubtedly appreciate that we hate to lose money. We are always trying to find areas of the market where risk/reward is skewed in our favour, and avoid areas where we are not being very handsomely compensated to take calculated risks. One of the areas that we have been very judicious with our allocations over the last year has been income-oriented equities. Investor demand in this area has been unabated and the premium being paid for all things "yield oriented" has forced valuations to unprecedented highs -- making us extremely selective.

When I started covering pipeline and utility-related stocks, they offered 5%+ yields and traded at 12-13x earnings multiples. Today those same "boring" stocks barely offer 3% yields and are 50% more expensive at 18-20x their underlying earnings. The driver here has been declining interest rates, making those stocks look more attractive relative to other yield-oriented instruments like government and corporate bonds. Suffice it to say, if you bought income-oriented securities in 2007-2008, you have done extremely well. This rising tide lifted all boats.

It appears the rapid ascension in interest rates of late (and subsequent correction in dividend-paying stocks) has forced many people to consider the question we have long been asking ourselves:

"What do we do if interest rates go up?"

In this environment, we will find out which interest-rate sensitive companies are good businesses and which have just been good stocks. This inflection point excites us at Cambridge greatly, as the benefit of stock picking returns.

Investing is never meant to be easy, but there are periods of time in every market it feels that way. In the 1990s, it was easy to generate returns and beat the market by taking on more risk than the market: if you managed your fund with a 1.8 beta, you were sure to win. (We all know how that turned out.) The commodity boom from 2002-08 and from 2009-11 made picking commodity stocks look easy. Among resource names, we are now seeing there is a difference between good businesses and good stocks (and very few are good businesses)!

When we look at income equities, the dividend yield is one of the last things we concern ourselves with. Shareholder returns are generated from three sources: dividends, share buybacks and growth in underlying cash flow per share. We are laser-focused on payout ratios and return on equity, as they will govern the growth rate of dividends in the future (far more important than the level of income today). In short, we would prefer a 2-3% sustainable and growing yield today than a 6% yield that, at best, is maintained or, worse, is at risk of being cut.

We try to find companies that pay out less cash flow than they generate, leaving room to reinvest excess cash internally at high returns. These companies will be able to continue to grow their dividends into the future because they are funded by value creation and cash flow growth, not financial engineering and leverage. If interest rates increase 1% but you can increase your dividend 10% a year, you remain an attractive investment. I highlighted one of these "smart income" names recently on our blog here: http://blogs.ci.com/cambridge/greg-dean/great-example-smart-income.

We employ this risk/reward framework in our equity funds and income-oriented funds with the caveat that our income unitholders have a lower tolerance for risk. We only want to take risks we feel we are being paid to take and in areas we know and understand. Two of our funds that I think are ideally suited for a return to a stock pickers’ market in income are Cambridge Canadian Asset Allocation Corporate Class and Cambridge High Income Fund.

The Asset Allocation fund is tactical (currently 70% equities) and offers exposure to total return equities, while the High Income Fund focuses more on current income (paying six cents per month), but with the same laser focus on payout ratios and the sustainability of the current income.

With income investing likely to become more difficult, our goal is to remain a trusted source for our clients, helping them navigate the volatility and achieve their long-term financial goals.

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