2014 was an interesting year for investors when it came to interest rates. There was almost unanimous consensus that bond prices would fall in the year, causing a rise in interest rates. But, that didn’t happen. Here’s how financial journalist Jason Zweig from The Wall Street Journal recently described it: “In The Wall Street Journal’s January 2014 economic forecasting survey, for instance, 48 of the 49 participating business economists expected the yield on the 10-year [U.S.] Treasury note, about 2.9% around the time of the survey, to exceed 3% by year-end, with an average forecast of 3.52%… …Other than…
2014 was an interesting year for investors when it came to interest rates. There was almost unanimous consensus that bond prices would fall in the year, causing a rise in interest rates. But, that didn’t happen. Here’s how financial journalist Jason Zweig from The Wall Street Journal recently described it:
“In The Wall Street Journal’s January 2014 economic forecasting survey, for instance, 48 of the 49 participating business economists expected the yield on the 10-year [U.S.] Treasury note, about 2.9% around the time of the survey, to exceed 3% by year-end, with an average forecast of 3.52%…
…Other than three days in January, the 10-year yield spent the entire year below 3%, and by late December it was around 2.2%.”
With interest rates defying investors’ expectations in 2014, what would it do in 2015? Thing is, no one knows. But that doesn’t mean investors shouldn’t be preparing for a possible rise in rates.
The impact of interest rates and how to deal with it
Changes in interest rates do not have a direct, predictable impact on stock prices, but debt which becomes more expensive can have a direct hit on the business results of heavily-indebted companies – that is what can cause the share prices of such companies to suffer.
On that note, investors who are worried about rising rates might want to consider financially rock-solid companies for their portfolios instead of financially weak ones.
Fortunately, there are no shortage of companies in Singapore with strong balance sheets. As of 31 December 2014, there are more than 300 shares listed here which have balance sheets (based on their last-reported finances) that carry more cash and equivalents as compared to total borrowings.
But, a strong balance sheet alone can’t tell us if a share would make for a good investment. For that, a deeper look at a share’s returns on equity would be helpful.
What strong finances really look like
Billionaire investor Warren Buffett considers a company’s returns on equity a very important metric. In his 1988 Berkshire Hathaway annual shareholder’s letter, he laid down a few criteria that he uses to evaluate businesses for potential acquisitions. One of them is the following:
“[B]usinesses earning good returns on equity while employing little or no debt.”
If we go back further to Buffett’s 1979 shareholder letter, he also spelled out just why a firm’s return on equity is important:
“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
Keeping Buffett’s thoughts in mind, I then dug deeper into that group of 300-plus shares to find (1) those with returns on equities of at least 15% on average (with no year dropping below 12%) since 2007, and (2) those having more cash than debt since 2007 (with only one year where cash is lower than debt allowed).
There are a few important points to note about why the criteria were used. The first was chosen because a return on equity of at least 15% is generally thought to be good and looking at a firm’s track record since 2007 gives us clues on how strong its business is since that timeframe is when the great financial crisis occurred.
As for the second criteria, it’s important to find out which are the firms which have earned their impressive returns on equity without use of heavy leverage. Thus, I specifically looked out for companies that have had largely more cash than debt over the years.
The great ones
With these criteria, shares like Raffles Medical Group Ltd (SGX: R01), Silverlake Axis Ltd (SGX: 5CP), Kingsmen Creatives Ltd (SGX: 5MZ), and Vicom Limited (SGX: V01) managed to filter through, amongst others.
Source: S&P Capital IQ
As seen in the chart above, all four aforementioned firms have achieved high average returns on equity of at least 17.5% in the seven years from 2007 to 2013 with the lowest figure in a calendar year being 15.0% (clocked by Raffles Medical).
Source: S&P Capital IQ
The next chart (seen immediately above) plots the net-cash balances for the quartet of shares from 2007 to 2013. And as can be seen, all four shares have had really strong balance sheets with a positive net-cash balance in all of those years. There’s a slight exception for Raffles Medical as it carried a tiny negative net-cash position in one year (2007) out of those seven.
For some perspective on how impressive the corporate results of the quartet have been, we can turn to the returns on equities and balance sheets of the 30 blue chips that make up Singapore’s market benchmark, the Straits Times Index (SGX: ^STI). Within the index, commodities trader Olam International Ltd (SGX: O32) had the median return on equity in 2013. The figure though, was just 10% – and the company did so while carrying a really high total debt to equity ratio of 234%.
A Fool’s take
Great corporate results from the quartet of shares have translated into equally commendable share price returns. Since the start of 2007, the Straits Times Index has seen its price grow by 13%, whereas Raffles Medical, Silverlake Axis, Kingsmen Creatives, and Vicom have achieved capital gains of 341%, 72%, 527%, and 413% respectively.
2015 might see interest rates rise or it might see rates fall. But regardless of what happens, the quartet, by virtue of their strong balance sheets, would likely not face high financial risks.
None of the above is to say that the quartet would continue to turn in market-beating performances. But, in the search for rock-solid shares to start 2015 with, the corporate track records of the four companies thus far might prompt investors to take a closer look.
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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 owns shares in Raffles Medical Group, Kingsmen Creatives, and Berkshire Hathaway.