It looks like the U.S. Federal Reserve is finally going to pull the trigger on an interest rate hike this fall. It has been a long time since Americans have seen an interest rate hike cycle, so Goldman Sachs Equity Research published a report titled Uses of cash, equity returns, and the business cycle to provide some historical perspective on how stock markets and specific industries have performed during past interest rate tightening cycles.
GS analyst Elad Pashtan and colleagues begin with an historical rule of thumb on interest rate cycles: “Firms investing for growth are rewarded during periods of improving GDP growth and rising interest rates, while firms returning cash to shareholders are rewarded when growth slows and rates decline.”
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Growth is rewarded during periods of rising rates
When the Fed hikes rates, capital costs will rise. This means the "potential returns" from spending/saving cash will shift materially. As the the interest rate cycle continues, American firms will see sustained increases in capital costs for the first time in almost 10 years. That said, more rapid economic growth is the prerequisite for rate hikes, so "investors will be more likely to reward firms positioned to grow sales and profits alongside the improving economy. In contrast, firms without the capacity to grow sales and profitability in this environment are likely to underperform."
That's why Pashtan et al. argue that investors will probably reward firms with strong capex and R&D spends. The GS analysts note: "During episodes of rising interest rates over the past 25 years, the top quintile of S&P 500 firms ranked by LTM capex + R&D to market cap outperformed the bottom quintile by an annualized 5%, and outperformed the S&P 500 80% of the time by an average of 600 bps. The top quintile of firms returning cash to shareholders via buybacks and dividends underperformed the equivalent bottom quintile by an average of 200 bps, and underperformed the S&P 500 60% of the time."
Growth via M&A strategy has spotty record
According to the Goldman analysts, the strategy of trying to "buy growth" via M&A to prepare for rising rates has a mixed record. They note that during the first half of 2015, the S&P 500’s top M&A spenders clearly outperformed others as growth ramped up and deal-making volumes surged to record highs. That said, the share prices of top M&A spenders have struggled historically, not keeping up with market returns more than 50% of the time over the last 25 years.
"Total cash return"-focused firms have strong long-term track record
For perspective, Pashtan and team also highlight that firms maximizing total cash return to shareholders have a "superior long-term track record across economic cycles." For example, a sector-neutral basket of the top quintile of S&P 500 stocks returning cash to shareholders via dividends and buybacks since 1991 has returned an annualized 15.7% compared to 13.8% for the top capex + R&D spenders and 12.8% for the S&P 500 index (equal-weighted).
However, the GS analysts do point out that the total cash return strategy’s long-term superior performance occurred during a period extremely low interest rates, making a projection of a similar future performance less reliable.
In concluding, the Goldman Sachs team suggests that investors consider their proprietary S&P 500 firms investing for growth (GSTHCAPX) basket given the rising rates environment likely to be seen in the near future.