WINNERS AND LOSERS IN THE FED´S NEW ERA / BARRON´S MAGAZINE

Streetwise

Winners and Losers in the Fed’s New Era

Shares of large companies with lots of cash and little debt could shine in 2016.

By Ben Levisohn           

Just as Bob Dylan going electric at the Newport Folk Festival in 1965 marked the end of one era and the beginning of the next, the Federal Reserve’s rate hike has likely marked the end of one investing paradigm and the beginning of a new one. Knowing how to navigate it could make the difference between boos or cheers in 2016.

Ever since the Great Recession, the Fed has been intent on boosting the economy by making money as cheap as possible. We can argue about what it’s done for the economy, but it has been great news for stocks, as well as companies that could borrow money cheaply and use it to spur growth.

With Fed Chair Janet Yellen’s decision to raise rates, however, those companies are likely to come under pressure, as investors look to businesses that don’t need easy money to thrive.

Instead, 2016 might be the year to focus on stocks that have been punished for not taking advantage of low rates: large companies with cash on their balance sheets and minimal debt.

While cheap money has been a boon for everything from small companies to highly leveraged concerns, it isn’t always what it was cracked up to be. For evidence, just look to the energy sector, which used access to cheap financing to drill, baby, drill—until the market was flooded with too much supply. As a result, energy stocks have dropped 21% this year.

What has happened in the oil patch might be just the beginning of the stress, now that the Fed has started hiking interest rates. Media stocks used cheap money to create more television shows and movies than anyone could hope to watch, and pay outrageous prices for sporting events, notes Michael Shaoul, chairman and CEO of Marketfield Asset Management. That glut has caused content to become worth less—Star Wars notwithstanding—and the problem is likely to get worse before it gets better. “The amount spent has been enormous,” Shaoul says. “Media is looking vulnerable.”

Other sectors that could be hit by oversupply include developers of multi-family dwellings; 360,000 rental units were built in 2014, more than in any year in the prior two decades. Even biotech companies could look vulnerable, if the Food and Drug Administration takes a dim view of the supply of new drugs hitting the market.

There’s a recipe for avoiding that kind of pain: Go where the money is. For years, companies that held massive amounts of cash on their balance sheet have been punished by investors; the companies in the Standard & Poor’s 500 with the most cash trade at a valuation roughly equal to those with the most debt, despite the fact that they’ve traded at a 50% premium, on average, since 1986, according to BofA Merrill Lynch data. That makes sense, considering that earning even a minimal return on cash was nearly impossible with rates near zero, putting a drag on returns.

With the Fed tightening, however, that cash will start to earn, well, something, and companies that need to borrow will have to pay more, says BofA Merrill Lynch strategist Savita Subramanian. That suggests, she says, “that companies with healthy balance sheets that can fund their own growth could re-rate, while levered companies could feel more pain.”

That means favoring high-quality over low quality companies, and large stocks that can fund their own operations over small companies dependent on capital markets for financing.

There’s another reason to favor large stocks over small: liquidity. Keeping rates low was just one part of repairing the U.S. economy. But regulators have also set out to make the financial system safer. To do so, they’ve made it difficult—if not impossible—for banks to step in and buy when everyone else is selling, instead forcing investors to find someone to take the other side of the trade. That means that some investments—think small-cap stocks and junk bonds—will become more difficult to buy and sell, as this month’s demise of the Third Avenue Focused Credit fund suggests. Small-company stocks, which have traded at a premium to large-cap stocks for much of the past 16 years, could end up trading at a discount, Subramanian says.

STILL, IT MIGHT BE worth taking a look at a small company if it’s already cheap, and holds oodles of cash. Ralph Coutant, portfolio manager at Matarin Capital Management, points to RetailMeNotsale in Your Value Your Change Short position (SALE), an online coupon marketplace that went public in 2013. The stock is cheap; having dropped 29% so far this year, after plunging 49% in 2014 due to falling earnings and revenue, shares now trade for just 1.1 times book value. The company’s saving grace is the cash on its balance sheet—$271 million, or $196 million minus debt—and $50 million annually of free cash flow.

No, this isn’t the high-flying growth stock everyone hoped it would be when it went public. But “it doesn’t need to move from good to great for investors to win,” Coutant says. “It just needs to move from bad to average.”