The Paradox of Higher Interest Rates & a Rising Stock Market
One of the tools the Federal Reserve (the Fed) uses to fight inflation is through raising interest rates, which theoretically, should slow down the economy via higher borrowing costs, lower stock prices and a stronger dollar. When interest rates rise, the presumption is that stocks tend to fall in value because of higher borrowing costs and lower capital investment. Additional pressure is brought to bear by consumers who rein in spending due to higher interest payments on mortgages and credit cards. The risk of using higher interest rates to slow the economy is that increased rates will flip the economy into a recession, but it is a risk the Fed believes worth taking to rein in inflation.
To tame inflation, the Fed has raised the benchmark federal funds rate at every meeting since March 2022 by a cumulative five percentage points, the most rapid series of increases since the 1980s. The federal funds rate is significant because the prime interest rate – the interest rate commercial banks charge their most credit-worthy customers – is largely based on the federal funds rate. It also forms the basis for mortgage and credit card annual percentage rates as well as a host of other consumer and business rates.
Despite the torrid pace of increases, inflation and economic activity have not slowed as many economic pundits anticipated this year, casting more uncertainty over how high they may lift rates later this year. Inflation has slowed to roughly 4% from 9% at its peak and remains stubbornly higher than the Fed’s target range of 2%.
Consumers are still spending, fortified by savings during the pandemic, healthy wage increases and lower gas prices. Payrolls grew by a surprising 340,000 jobs in May. It was the fourteenth straight month the increase in payrolls exceeded expectations. Job openings increased to 10.1 million in April, up from 9.7 million in March; and average hourly earnings grew a solid 4.3% from a year earlier. The number of travelers passing through U.S. airports during Memorial Day weekend exceeded the pre-pandemic number from 2019, despite the fact that consumers are paying more to book an airline ticket or reserve a hotel room.
At the last Fed policy meeting at the end of June, officials kept the federal funds rate in a range between 5% and 5.25%, pausing increases. The pause was to “assess the cumulative tightening of monetary policy” on economic activity. What happens next depends largely on Fed Chairman Jerome Powell. The break from credit tightening could delay the reckoning on inflation and thus the anticipated downturn is merely pushed down the road.
What happens next depends largely on Fed Chairman Jerome Powell. The break from credit tightening could delay the reckoning on inflation and thus the anticipated downturn is merely pushed down the road.
Decades of prior research, including that of economist Milton Friedman, indicated that any changes in monetary policy would have a “long and variable lag” effect on the economy. By “long and variable,” the consensus of the research suggests a lag of a year to affect gross domestic product (GDP) and an additional year before it affects inflation. These time frames are not precise; some policy adjustments have gone faster and some slower.
At the end of June, the Standard and Poor's 500, a common index of the stock market, was up almost 16% despite the rapid and steep rise in rates. Higher interest rates may yet have a meaningful impact, delayed by Friedman’s “long and variable lag,” or it may prove that the level of increases was insufficient to cool this particular business cycle, propelled by suppressed demand and fiscal stimulus emerging from the pandemic. The takeaway for the investor is that projecting the direction and timing of the market – or the economy for that matter – from changes in interest rates is dicey. Not every sector or stock will fall just because interest rates are rising. Companies with strong balance sheets, established track records, competitive moats and pricing power are the best positioned to handle the volatility that comes with higher rates. Active investment managers are tasked with finding just such companies.
June 30, 2023
Company Comments
Comments follow regarding common stocks of interest to clients with stock portfolios managed by Delta Asset Management. This commentary is not a recommendation to purchase or sell but a summary of Delta’s review during the quarter.
Caterpillar Inc. {CAT}
Founded in 1925, Caterpillar is the world’s largest manufacturer of construction and mining equipment, with 2022 sales of $59.4 billion. The company also manufactures and sells diesel and natural gas engines, industrial gas turbines and electro-diesel locomotives. The company’s products are used in road building, mining, logging, agriculture, petroleum and general construction. Specific products include tractors, scrapers, graders, compactors, loaders, off-highway truck engines and pipe layers. The company’s global reach is evidenced by its nearly 56% of revenue generated outside the U.S.
CAT is a leader in the global new construction equipment market. The company has built its product portfolio and significant scale through a combination of organic initiatives and acquisitions. CAT is either the largest or second-largest manufacturer of virtually every product it makes, and it generates a high return on capital. We believe the CAT brand, manufacturing scale and vast dealer network will help lead to market share growth, healthy global expansion, and high profitability.
Many equipment customers state that responsive aftermarket product support is a key differentiator in the purchasing decision. Equipment downtime on a schedule-driven project can cost millions of dollars.
Caterpillar has made the transition to a more outsourced business model to create a less cyclical business and to reduce their break-even production levels. CAT began this transition in 2014 by closing and consolidating numerous facilities, reducing its manufacturing floor space considerably. CAT now outsources 75% of the parts that go into its equipment. During this period, operating margins improved from mid-single digits to over 13%.
Caterpillar’s equipment is distributed through a worldwide network of 156 independent dealers located in over 192 countries with more than 2,000 dealer branches. The strong dealer support network is a key component to Caterpillar’s success and is a competitive advantage. Many equipment customers state that responsive aftermarket product support is a key differentiator in the purchasing decision. Equipment downtime on a schedule-driven project can cost millions of dollars.
Caterpillar has shifted its operational planning to focus more on return on investment versus incremental margin when evaluating its efficiency of capital in making investments. The company allocates higher capital investment to higher-return businesses and restricts capital investment in businesses generating subpar returns. Targeted organic growth areas include a major push to increase its service and parts along with expanded and upgraded equipment offerings. CAT expects to double its higher-margin parts and service business over the next several years. New equipment is expected to drive growth through increasing market share, including digital applications aimed at machine connectivity, data collection and predictive analytics as well as electric-powered machines and automated trucks.
The company faces a range of operational and financial risks. Performance can be impacted by rising interest rates, unfavorable exchange rate movements, declining commodity prices and economic weakness. Longer-term challenges include regulatory emissions standards requiring CAT to make significant investments in research and development (R&D) to meet stricter requirements. In addition, CAT faces more competition in its faster-growing international markets.
China’s appetite for commodities is a key driver of global commodity prices. China’s government boosted infrastructure work following the global financial crisis in 2008. The construction industry’s share of the country’s gross domestic product rose from 5.9% in 2008 to 6.9% in 2022. China has experienced an economic contraction recently due to the COVID-19 pandemic, but a recovery appears to be underway. With construction and resource segments making up over 50% of Caterpillar’s sales, its share price has tended to move with commodity prices. Continued urbanization and infrastructure improvements globally should bode well for Caterpillar over the long term. The company continues to expand its manufacturing facilities in emerging markets and is increasing its exposure to mid-tier markets through simpler, non-Caterpillar branded equipment to appeal to the cost-conscious buyer.
We believe the company has sustainable long-term competitive advantages and can grow revenue in the low single digits over the next decade. Efficiencies gained through leaner manufacturing processes and competitive returns from R&D spending should enable the company to experience free cash flow margins of over 8%. Based on these assumptions, our financial model indicates that at the current stock price, Caterpillar’s stock offers a potential long-term annual return of approximately 5.8%.
Comcast Corporation {CMCSA}
Comcast is the nation’s largest cable provider offering a range of information, entertainment and communication services to residential and commercial customers. The cable segment’s network is complete with video, high-speed internet (HSI), voice as well as digital video and wireless services that can be accessed by 61.4 million homes and businesses in 39 states representing more than 40% of all U.S. households. The company’s NBCUniversal business is a leading entertainment and media company that develops, produces and distributes news, sports and entertainment for global audiences.
Comcast’s cable segment is mature with subscriptions for video declining and broadband growth slowing. As a result, the firm has shifted focus to increasing average revenue per unit (ARPU) served, which is done by capitalizing on the speed differential with periodic price increases and bundling services. ARPU for the most recent quarter increased 4.5%, the fastest pace in two years.
A critical Comcast defense is its industry-leading internet speeds. With the continuing shift toward online and mobile video and gaming, internet speeds are vital to continuing to drive growth in its high-margin HSI business. Data consumption growth continues to drive the importance and value of Comcast’s faster pipe into homes and businesses.
Comcast’s network architecture allows it to add capacity to meet customer speed demands at a far lower cost than competitors. In addition, Comcast Business Services continues to be a high-margin growth driver for the company. It is now a $10 billion business growing at a high single-digit rate. Future growth prospects in this segment hold promise with currently just a 15% to 20% market share and an estimated $20 to $30 billion market opportunity.
Data consumption growth continues to increase the importance and value of Comcast’s faster pipe into homes and businesses.
Comcast’s NBCUniversal has experienced the success of a robust turnaround. Comcast has significantly improved this collection of businesses, which includes cable networks, NBC broadcast stations, movie studios and theme parks, which provide adequate growth and good cash flow. Comcast is investing to transform the entertainment unit into a compelling multi-media juggernaut with the parent company’s ample capital, scale and digital know-how. Its central focus will be sports and top-echelon theme parks. With investments in NASCAR, NCAA football, NFL football, Olympics and Premier League soccer, it is betting it can boost fees and advertising. Sports are “must-see” live events, whether at home or digitally while on the go, and still command premium ad rates.
The company has rolled out a new streaming service to compete in the direct-to-consumer market. The offering, named Peacock, will have access to a vast library of popular content such as Yellowstone and The Office as well as new original content and live sports such as golf, NASCAR, NFL and Premier League Soccer. Peacock recently struck a reported $110 million deal with the NFL to broadcast one of two playoff games during primetime in January 2024.
Comcast owns one-third of Hulu. Under an agreement with Disney, beginning in 2024, Disney can exercise its option and acquire Comcast’s stake for $9.5 billion or potentially more depending on the result of an independent appraisal.
Comcast has many positive attributes, including recurring, predictable cash flows and competitive advantages, such as substantial scale and a fully built-out network. The significant capital investment needed for a new entrant to build a competing network serves as a barrier to entry and limits the ability to compete on price. With its network complete, Comcast can add new subscribers and improve the speed and capacity with only modest additional costs, while increasing overall return on investment.
Comcast continues to operate exceptionally well with good growth and robust free cash flow. The company has a number of responses to the various competitive threats it faces; however, we believe it is prudent to expect modest revenue and earnings growth over our forecast horizon. Our stock valuation model estimates a long-term annual return for Comcast of over 11% based on its current stock price.
Nestle S.A. {NSRCY}
Nestlé is the largest food and beverage company in the world with operations spanning the globe. The company is a leading player in several categories, including coffee, dairy products, confectionery, prepared foods, pet food and infant and adult nutrition. More than 30 of Nestlé’s brands generate in excess of $1 billion each in annual sales. The company has been very successful at establishing positions in growing product lines, generally through acquisition, and then nurturing those brands to further prominence. The company’s advantages include its leading brands, significant economies of scale and an extensive global distribution network. Nestlé controls the No. 1 or No. 2 global market share position in the majority of its categories, which generally have lower private label competition. The company’s unmatched investment in R&D has driven innovation, particularly toward differentiated health and wellness products. Nestlé’s strong brand support should continue to strengthen its overall market position. Substantial marketing support and its market share positions give Nestlé a relatively strong standing to negotiate with retailers for primary shelf space, strengthening its competitive position.
Nestlé controls the No. 1 or No. 2 global market share position in the majority of its categories, which generally have lower private label competition.
Nestlé is a core supplier to grocery stores across the globe. The company’s decades-old global operations and investments have created meaningful scale and dense distribution networks and have established brand reputation in 189 countries, including a significant presence in faster-growing emerging markets. The company has operated in most of its countries and markets for generations with consumer and supplier relationships dating back many years.
Nestlé’s superior geographic and category mix should allow it to grow faster than most of its peers. Further helping drive growth will be increased product portfolio investments into faster-growing categories, such as coffee, pet food and nutritional supplements as well as affordable high-quality nutritional food products in emerging markets. Nestlé is heavily exposed to emerging markets to the tune of an estimated 40% of sales. The company’s focus on localized distribution networks, manufacturing and raw material sourcing should position Nestlé for continued growth and high margins in these markets. Good execution of cost-saving initiatives has led to industry-leading cash flow margins that we expect to increase over time.
Nestlé faces its share of challenges, including the consolidation of its retail customer base. The proliferation of low-price store brands continues to be a threat industry-wide, especially with hard discounters, such as Aldi growing throughout the U.S. Consumers are increasingly gravitating towards natural and organic foods. They are also buying more fresh foods, as opposed to frozen, processed, and packaged foods. These changes have a negative impact on all food manufacturers, including Nestlé. Inflation and supply chain disruptions have also weighed on company margins. Supply chain disruptions are temporary, and we believe Nestlé’s brands and product categories will maintain pricing power and remain competitive in inflationary environments.
Given our expectations for worldwide growth in food and beverage markets and Nestlé’s mix of faster-growing, high-margin categories, we believe Nestlé can grow revenues at 4% annually over the next decade and increase its cash flow margin to 22%. We believe Nestlé will be able to maintain strong pricing in the face of inflation and offset potential pricing pressures from both major retailers and increased competition through the continued execution of a number of cost-efficiency programs adopted in recent years. Based on these assumptions, our stock evaluation model indicates Nestlé’s current stock price offers a long-term average annual rate of return of approximately 6.0%.
Ecolab Inc. {ECL}
Ecolab is the largest global provider of water and hygiene technologies and service programs, providing services in over 170 countries to nearly 3 million customer locations. Its products and programs serve many different industries, such as food and beverage, hospitals, life sciences, hospitality and food service. Ecolab was founded in 1923 and is headquartered in St. Paul, Minnesota.
Ecolab’s exposure to water has been primarily through acquisitions. The company provides chemicals, services and analytics to help commercial and industrial customers manage water quality, treat boiler and cooling water, and manage and reduce wastewater. Ecolab’s water-treatment programs serve global industries, including food and beverage, manufacturing, pulp and paper production, mining, and energy. The company’s core strength of helping customers reduce, reuse, and recycle water is becoming increasingly important as water becomes scarcer in the long term.
Ecolab uses a razor and blade business template by loaning customers cleaning equipment that can only use Ecolab branded consumables. The installed base and consumables model creates recurring revenue streams and high customer switching costs.
In providing a comprehensive set of innovative cleaning, sanitizing and water treatment programs, products and services the company pursues a “Circle the Customer – Circle the Globe” strategy. The company dwarfs its rivals in a highly fragmented market. Ecolab’s extensive and highly trained sales force has been a key contributor to strengthening and growing its leadership position in the industry. New customers over time are offered other new products and solutions, thus expanding the relationship and adding incremental revenue. These customer relationships also provide valuable customer insight, which often leads to product innovation. The sales force stays in close contact with customers by visiting sites to ensure that the company’s products are working and being used properly. Salespeople are highly motivated with as much as 75% of compensation in the form of variable pay.
Ecolab uses a razor and blade business template by loaning customers cleaning equipment that can only use Ecolab branded consumables. The installed base and consumables model creates recurring revenue streams and high customer switching costs. In addition, many of the company’s products and services are complementary to one another and across industries. There continue to be good cross-sell opportunities between legacy Ecolab and its water treatment services. Its water applications already service hotels, hospitals, commercial buildings and food and beverage customers. This customer overlap should enable Ecolab to further “Circle the Customer” by selling new products and services to established customers and vice versa.
The company employs over 1,200 scientists, engineers and technical specialists to develop products and services to improve hygiene, efficiency and product quality. The company’s core technologies include antimicrobials, dispensing and monitoring, environmental hygiene, polymers, water management and data analytics. Its R&D efforts resulted in the formulation of OxyCide, a cleaning concentrate that kills C. difficile, a leading hospital-acquired bacterial infection, in half the time of traditional disinfectants. Ecolab’s R&D efforts and broad product portfolio are centered around positive secular themes, such as water management and good health and hygiene.
Based on its business attributes as a whole, we have assumed Ecolab can grow revenue at an average annual rate of approximately 5% over the next decade. Given the consolidation of acquired businesses and expectations of improved European profitability, we believe cash flow margins will average just over 22% during our forecast period. Using these assumptions and based on current market valuation, Ecolab’s expected average annual rate of return is almost 6%.
Dated: June 30, 2023