Stock Rover's Year-End Picks (with Rising Interest Rates in Mind)

December 18, 2015 |

Here at Stock Rover we’ve put together a list of stock picks of the moment, keeping in mind that the Fed has just started the process of peeling the federal funds rate off the floor. If you aren’t totally clear on what a rising rate environment is, or what it means for you as an investor, check out our Notes on an Interest Rate Rise article.

So here are 11 staff picks, organized by sector. Note that many of our recommendations from August still stand, but in the interest of showcasing some fresh ideas, we are not including any of those in this list. And as usual, a friendly reminder to not just take our word for it: do your own research and come to your own conclusions before investing your own money.

Financial Services Sector

In an improving economy, there is more financial activity in general, which reverberates positively throughout the financial services sector, making it the top sector to turn to when rates rise. Banks in particular have an edge when rates are rising because they can directly profit from the spread between the interest rate they earn on debt versus the interest they pay out to savers.

Here are a few financial stocks for your consideration, compared in a smattering of balance sheet, valuation, and profitability metrics:
financial sector table

And here is a chart comparing their dividend-adjusted performance relative to the financial services sector (set as a baseline in light green) over the past 5 years:
financial sector chart

As you can see, all four have vigorously outperformed their sector in this period, with margins ranging from 64.6% to 365.9%.

For a conservative bank pick, take a look at US Bancorp (USB). USB is a slow growing regional bank that, as far as we know, hasn’t done stupid things. Its financials are good, showing steadily growing sales and earnings, solid cash flow, a slowly-declining debt/equity. Depending on the metrics you use, you may consider this stock to be cheap or fairly valued, but it’s certainly not expensive. We would call it a GARP play for the risk-averse.

Visa (V) and MasterCard (MA) are by no means cheap, but they are both seasoned powerhouses of profitability, with little to no debt and steadily increasing price performance. They both have intelligent business models, which allow them to take advantage of the ballooning volume of electronic transactions without assuming any credit risk. Look to your favorite technicals to determine a good local entry point if you decide you want to attach yourself to one of these seemingly sky-bound stocks.

To probe another corner of the financial world, check out AmTrust Financial Services (ASFI), a mid-cap insurance company that is favored by the handful of analysts that follow it (4 of 5 rate it a “strong buy”). The stock’s performance in the past year has been rocky, but it has heartily outperformed its sector, industry, and the market over the past 2-5 year periods, and has done so with moderate to low volatility and beta. AFSI has demonstrated consistent and healthy growth that is expected to continue into the next year. It also has strong cash flow and free cash flow, plus a generally increasing interest coverage ratio. AFSI has also consistently raised dividends since 2007, while maintaining a payout ratio below 20%. Earlier this year, we were concerned about AFSI’s high short interest, but since that has come way down (currently at 8.1%), we have welcomed it as an intriguing newcomer to our watchlist.

Consumer Cyclical

In a strong economy, consumer cyclical companies can benefit from an increase in discretionary spending. Furthermore, a lot of retail sectors have just had a pretty ugly year, so bargains abound. Here are three retail stocks that we think could be great values, again shown with some key metrics:
consumer cyclical table

Goodyear Tire & Rubber (GT) has a solid franchise, with good products, and it seems to be getting smarter as a company. It has succeeded in bringing its debt/equity way down from an astounding 13.8 in 2012. At the same time, it has been increasing its earnings, cash flows, and operating efficiency (as expressed by the ROA, ROE, ROIC, and operating margin) while boasting a very, very low P/E (thanks to huge Q4 earnings) and debt-adjusted P/E as well as a forward P/E of less than 10. It started paying dividends a few years ago, and we think it has the potential to be a great dividend grower—that is, a company that is both appreciating in value and growing its dividend.

Apparel retailer Michael Kors (KORS) had a rough year (-45.6% YTD at the time of writing). But we think it’s reaching a price support and, as you can see in the table above, its poor price performance has led to very low P/E, adjusted P/E, and P/FCF, making it inexpensive. We like the company, among other reasons, for its debt-free balance sheet, excellent profitability (in the top 10% of its industry), increasing cash flows, and increasing ROIC. Its spectacular sales growth from a few years ago has normalized, but sales are still growing at a modest rate—4.1% is expected next year. Management has recently re-emphasized product design and variety (like wearable tech), which has so far paid off in higher comps. Once a high growth company, we believe KORS is reestablishing itself as a GARP or even a value stock that is growing.

Similar to KORS, Dicks Sporting Goods (DKS) has also had a down year (-25.0%) with disappointing earnings reports. But now we see a lot of upside, based on the company’s well-defended position as the top sports and fitness retailer in the US. DKS boasts solid profitability (also in the top 10% of its industry), steady earnings and sales growth, slowly rising cash flows, and low debt. It also pays dividends, with plenty of headroom for dividend growth. Having shopped at Dick’s, we are impressed with their stores, which offer a huge variety of merchandise, including all the major brands, in an attractive store layout. We think it’s growth at a more-than-reasonable price.

Industrials

The industrials sector benefits from low cost fuel and from an increase in discretionary spending. Right now we are particularly fond of the airline industry, which we’ve covered several times on our blog in the past. Some of our earlier picks such as Alaska Airlines (ALK) and JetBlue (JBLU) still stand. Below are two more for your consideration. Since there are just two, I included historical data so you can see how they have performed in these metrics over time:
dal luv

Both Delta Air Lines (DAL) and Southwest Airlines (LUV) could be high fliers (sorry, painfully obvious airplane metaphor!). We think Delta is one of the best run major carriers. Although its financials have been uneven over the years, the company has recently been moderately growing sales, increasing cash flow, decreasing debt/equity, and decreasing its share count. This Seeking Alpha article offers more depth on why DAL could be a good pick for the coming year. The analysts agree: 9 of 10 give DAL a “strong buy” rating. File it under GARP.

For a more domestically focused airline, there is Southwest, which appears to be healthy as a horse, financially speaking, and has seen strong earnings growth that is expected to continue. Highlights include a decreasing share count, a decreasing debt/equity, positive cash flows, and increasing operating margin, ROIC, ROE, and ROA. It’s also the cheapest it has been in a while—a cool 16.3 P/E, which is average for the industry, but low for LUV. It also has the very attractive PEG Forward of 0.4, meaning it could be very cheap considering its expected growth.

Two More for the Road

Here are a couple of picks in sectors that tend to be relatively neutral in a rising rate environment (again showing historical data):
dal luv

Dollar General (DG) is a consumer defensive pick to consider. If the economy were to react poorly to a rise in interest rates, discount retailers could very well benefit. Despite its highly competitive industry, we think DG knows its market and makes smart real estate and inventory choices as it expands. These have been validated by solidly growing earnings, sales, and cash flows, and consistently decent profitability indicators. Although not quite as inexpensive as its merchandise, DG is a reasonably-priced growing company.

Avago (AVGO), a tech company with a focus on wireless communications, has been leaving its industry and sector in the dust. Its fantastic price performance means that the stock is decidedly not cheap, with a P/E of 57.0 (although its forward P/E is under 14). We think it could be a bright pick for growth investors. The semiconductor company has made some ingenious choices that would seem to position it very well for the future. These include merging with Broadcom and pursuing profitable (if esoteric) tech avenues like wireless radio frequency filters. This Seeking Alpha article offers more detail about AVGO’s clever niche within its industry.

Summary

These 11 picks have caught the attention of the Stock Rover team. While they range on the value/growth spectrum, we believe they are all quality companies that will not falter—and in fact may thrive—in a rising interest rate environment. You can get a watchlist of these stocks (plus a few bonus picks!) from our library.

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