To Investors in Shares: Don’t Bother With Interest Rates

Last weekend, I was at the Investment Opportunities In The Singapore Stock Market seminar co-organised by Singapore Exchange and Shareinvestor. My colleague David Kuo was giving a speech and I was there to watch (check out The Motley Fool Singapore’s Facebook page for some pictures of the event).

Throughout the course of the seminar, there was one strong theme which stood out: Investors were very concerned with the current low interest rate environment and its potentially negative effects on the stock market if rates start creeping up. The general idea is that stock market valuations would fall if interest rates go higher; and when valuations fall, stock prices have to fall too if earnings stay constant.

For me, I find that investors’ concerns over interest rates are overblown. And it’s not because interest rates won’t rise (frankly, no one knows for sure what interest rates will do in the future) – it’s because the movement of interest rates can’t tell you what stocks will do.

Economics professor and recent Nobel Prize winner Robert Shiller has done the investing world a wonderful favour by making long-term U.S. stock market data (it goes all the way back to the latter half of the 1800s!) available for free to all. Within his set of data lies an interesting chart which plots the movement of U.S. long-term interest rates with U.S. stock market valuations as measured by the CAPE (cyclically adjusted price earnings) ratio. I’ve used his data-set to recreate a part of his chart for the period from 1930 to July 2014.

S&P 500 CAPE Ratios and Long-term interest rates

Source: Robert Shiller

As you can see, beginning from the early 1930s, there was a good three decades-plus period where rising interest rates coincided with rising valuations. It was only in the early 1980s when falling interest rates were met with rising valuations. For me, this chart is a great example of how the movement of interest rates can’t tell us much (if anything at all) about where stocks would go next.

So, to investors in the share market: What interest rates can do to valuations – and by extension, share prices – would really not be worth fretting over.

Instead, the focus should be on the businesses underlying the shares you own as it really is the performance of the business which drives a share’s returns over the long-term. And on that note, investors might still want to keep an eye on what interest rates will do – and that’s because heavily-leveraged companies might find their operations being negatively impacted should interest rates rise for extended periods of time.

It’s all the more onerous for heavily leveraged companies that have: 1) floating interest rates for a significant portion of their borrowings; and/or 2) difficulty in generating positive operating cash flow.

It’s hard to get finer details on companies’ balance sheets based on their latest quarterly filings (details like the interest rates on their borrowings and whether they have floating or fixed-rates often can’t be found in quarterly filings), but it’s still possible to tell how heavily levered they are and how cash-generative their businesses can be.

With these in mind, I ran a screen in S&P Capital IQ for companies listed in Singapore with the following criteria: 1) A net debt (total borrowings minus total cash & short-term investments) to equity ratio of more than 200% currently; and 2) negative operating cash flow over the last 12 months.

Of those that filtered through, the five companies with the highest market capitalisations are, in descending order, Neptune Orient Lines Ltd. (SGX: N03), Oxley Holdings Ltd (SGX: 5UX), Aspial Corporation (SGX: A30), Vallianz Holdings Ltd (SGX: 545), and Tiger Airways Holdings Limited (SGX: J7X).

Company Net debt to equity ratio 
Neptune Orient Lines 202%
Oxley 394%
Aspial 243%
Vallianz 253%
Tiger Airways 926%

Source: S&P Capital IQ

None of the above is to say that the quintet would make for bad investments going forward. But for investors worried about rising interest rates, it would be companies like the aforementioned ones which should be watched closely as they’re exposed to larger financial risks.

For more free investing analyses and important updates about the share market, check out the Motley Fool's weekly investing newsletter Take Stock Singapore. This free newsletter can teach you how to grow your wealth in the years ahead, so do check it out here.

Also, like us on Facebook to follow our latest news and articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.