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Guide To Interest Rate Hikes And ETFs: 4 Ways To Play

Amid spiraling woes, the China-led global deceleration fear in particular, the question that Wall Street is raising is whether the Fed will finally raise the first interest rates in almost a decade later this month. While the recent global rout could put a pause on the September lift-off, a series of upbeat data on the domestic front is supporting the prospect of a rates hike. Data Supportive of Rates Hike The U.S. economy is on a firmer footing, having expanded 3.7% in the second quarter. The number is well above the initial reading of 2.3% and 0.6% growth in the first quarter, suggesting that the U.S. could easily withstand the China turmoil and global growth worries. Trade gap narrowed 7.4% from June to $41.9 billion in July, the smallest since February. Exports rose 0.4% amid a strong dollar and weakness in major trading partners such as China and Europe. Consumer credit has been on the rise over the past four years, a sign of confidence amid low gas prices and steady job creation. Further, the housing market has been firing all cylinders thanks to soaring demand for new and rented homes, rising wages, accelerating job growth, affordable mortgage rates and of course increasing consumer confidence. The August job data, which is the most important indicator of the Fed policy, has been mixed. Though the U.S. added fewer-than-expected jobs tallying 173,000 in August, the drop in the unemployment rate and acceleration in average hourly wages kept the prospect of a September lift-off alive for later this month. In fact, the unemployment rate dropped from 5.3% in July to a seven-and-half year low of 5.1%, a level that the Federal Reserve considers as full employment while average hourly wages rose a modest 0.3% from the prior month and 2.2% from the year-ago level. These suggest that the labor market is healing. Inflation remains soft, but has been increasing steadily this year and is expected to touch the 2% target on a improving economy, marked by a steady labor market and a strengthening housing sector. However, uncertainty still looms around the timing of interest rates given the turmoil in China, trickling oil prices, and a slowdown in key emerging markets. Any Reason to Worry? Higher rates would attract more capital to the country from foreign investors, thereby boosting the U.S. dollar against the basket of other currencies. This would have a huge impact on commodity-linked investments, reflecting that a rising rate environment will hurt a number of segments. In particular, high dividend paying sectors such as utilities and real estate would be the worst hit given their higher sensitivity to rising interest rates. Further, securities in capital-intensive sectors like telecom would also be impacted by higher rates. In this backdrop, investors should be well prepared to protect themselves from higher rates. Here are number of ways that could prove extremely beneficial for ETF investors in a rising rate environment: Insurance Insurance stocks are one of the prime beneficiaries of a rate hike, as these are able to earn higher returns on their investment portfolio of longer-duration bonds. But at the same time, these firms incur loss as the value of longer-duration bonds goes down with rising interest rates. Nevertheless, since insurance companies have long-term investment horizons, they can hold investments until maturity and hence, no actual losses will be realized. While there are number of insurance ETFs, SPDR S&P Insurance ETF (NYSEARCA: KIE ) could be a good bet. This fund follows the S&P Insurance Select Industry Index and offers an equal weight exposure to 52 stocks, suggesting no concentration risk. About 39% of the portfolio is allocated to the property and casualty insurance while life & health insurance accounts for one-fourth share. The ETF has managed $523 million in its asset base and trades in a moderate average daily volume of over 96,000 shares. It charges 35 bps in annual fees and has a Zacks ETF Rank of 3 or ‘Hold’ rating with a Medium risk outlook. Financials A look to the broad financial sector is also a good option, as a steeper yield curve would bolster profits across various corners of the segment. Not only will insurance stocks climb, banks and discount brokerage firms will also be the winners in a rising rate environment. A broad way to play this trend is with Financial Select Sector SPDR Fund (NYSEARCA: XLF ), having AUM of $17.4 billion and average daily volume more than 33 million shares. The ETF follows the S&P Financial Select Sector Index, holding 90 stocks in its basket. The top three firms – Wells Fargo (NYSE: WFC ), Berkshire Hathaway (NYSE: BRK.B ) and JPMorgan Chase (NYSE: JPM ) – account for over 8% share each while other firms hold less than 5.9% of assets. In terms of industrial exposure, banks take the top spot at 36.9% while insurance, REITs, capital markets and diversified financial services make up for a double-digit exposure each. The fund charges 15 bps in annual fees and has a Zacks ETF Rank of 1 or a ‘Strong Buy’ rating with a Medium outlook. Short-Duration Bonds Higher rates have been cruel to bond investors, especially the longer term, as an increase in rates has always led to rising yields and lower bond prices. This is because price and yields are inversely related to each other and might lead to huge losses for investors who do not hold bonds until maturity. As a result, short-duration bond are less vulnerable and a better hedge to rising rates. While there are several options in this space, iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) seems to be intriguing choice. It has a solid $12.5 billion in AUM and is highly traded with more than 1.2 million shares a day on average. The ETF follows the Barclays U.S. 1-3 Year Treasury Bond Index, holding 83 bonds in its basket with average maturity of 1.87 years and effective duration of 1.84 years. It has 0.15% in expense ratio and has a Zacks ETF Rank of 3 with a Low risk outlook. Inverse ETFs Investors worried about higher interest rates could also go short on rate sensitive sectors like utilities and real estate via ETFs. There are a number of inverse or leveraged inverse products currently available in the market that offer inverse (opposite) exposure to these sectors. While a leveraged play might be a risky option, inverse ETFs are interesting choices and provide hedging strategies in a rising rate environment. In this regard, ProShares Short Real Estate ETF (NYSEARCA: REK ) seeks to deliver the inverse return of the daily performance of the Dow Jones U.S. Real Estate Index. The product has amassed $34.4 million in its asset base while volume is moderate at around 81,000 shares a day. Expense ratio came in at 0.95%. Original Post

September QTD, YTD Asset Class Performance

Below is an updated look at the recent performance of various asset classes using our key ETF matrix. For each ETF, we highlight its performance so far in September, in the third quarter, and for the full year. Share this article with a colleague

Paying A Premium For Water

Summary Aqua America provides an essential business that churns out profits year after year. In 2005, investors were willing to pay an extraordinary premium for the company. This article details what occurred as a result of this valuation, along with some takeaways that can be gleaned. Roughly, 3 million people living in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia likely know Aqua America (NYSE: WTR ) as their water utility. Income investors probably recognize the company by its dividend program: having paid consecutive quarterly dividends for 70 years and increased this payout for 24 years. Of course, to generate these payments you need a solid underlying business to fuel the payout growth. To this point, the company has been quite consistent – increasing earnings per share in nine of the last 10 years – and earning reasonable returns on shareholder capital. Of course, this is more or less to be expected. When you sell a good everyone desires and deems essential, it follows that even with regulation, you stand to make a profit. Comparing the major components of Aqua America over the years can better illuminate this strong history along with how investors have valued the company. Business performance is one thing, but investment results can be altogether different. Revenue By the end of 2005, Aqua America was generating nearly $500 million in revenue. Nine years later, that amount had grown to $780 million, or a compound annual growth rate of about 5.1% per annum. This represents reasonable, albeit not astounding growth. Earnings Based on the $500 million in revenue during 2005, the company earned about $91 million for a net profit margin of roughly 18%. By 2014, this margin had climbed to over 27%, resulting in total earnings of nearly $214 million. On an average compound basis, this represents 9.9% yearly growth. This is a bit more impressive. Naturally, the repeatability might be a bit more difficult – you can’t grow margins forever – but it nonetheless provided a nice boost during this time frame. Earnings Per Share If the number of shares outstanding remains the same over the period, total company earnings growth will be equal to earnings per share growth. Yet this situation rarely holds. Many dividend growth companies routinely retire shares over the years. Utilities tend to issue shares due to the capital-intensive nature of the business. At the end of 2005, Aqua America had about 161 million shares outstanding. By the end of 2014, this number had climbed to 179 million, or an increase of 1.1% per year. As a result, earnings per share did not grow as fast as total earnings, coming in at 8.6% per annum. Share Price This is where things get interesting (or cautious depending on your viewpoint) in reviewing the company’s history. At the end of 2005, shares of Aqua America were trading hands around $22. This represents a trailing earnings multiple of about 38. Now surely, Aqua America is a solid company with a proven track record and the ability to meaningfully grow both its business and payouts over time. Yet paying nearly 40 times for a water utility doesn’t appear especially compelling. Indeed, by the end of 2014, the share price had only climbed to $26.70, representing an earnings multiple of about 22. This is the type of thing that you have to watch out for. First, you want to find a solid business, but the next step is to determine whether or not the price paid is roughly fair. In this instance, investors saw the share price greatly underperform the business due to the initial valuation paid. Earnings per share grew by 8.6% per year, yet the share price only grew by 2.3% annually. Total Return Note that while the P/E compression was quite imposing – going from 38 to 22 – it wasn’t the difference between positive and negative. Over longer time periods, investors still would have seen positive (albeit greatly trailing) returns. Over this period, an investor would have collected about $4.30 in dividends, or roughly 20% of your beginning investment. This is a bit more impressive than it seems, it’s just that the starting price paid distorts the benefit of a solid and increasing dividend. Overall, investors would have seen annual returns of about 4% per year. Here’s a summary of the above progression: WTR Revenue Growth 5.1% Start Profit Margin 18.4% End Profit Margin 27.4% Earnings Growth 9.9% Yearly Share Count 1.1% EPS Growth 8.6% Start P/E 38 End P/E 22 Share Price Growth 2.3% % Of Divs Collected 20% Start Payout % 56% End Payout % 53% Dividend Growth 7.8% Total Returns 4.0% As noted, revenue growth was reasonable, while earnings growth was quite solid. (Although these growth rates are partially attributable to a robust acquisition strategy.) The company routinely issued shares, resulting in EPS growth of about 8.6% per year. The first few parts appear relatively normal. In knowing that a company grew earnings per share by 8% to 9% annually, you might suspect that the investment performance was strong as well. Yet this wasn’t the case. Instead, due to a high relative starting multiple, P/E compression gobbled up a lot of the potential. Business performance and investment performance were two drastically different things due to the value others were willing to pay. It’s not that the business wasn’t solid or that you didn’t keep enjoying a higher and higher dividend payment – both situations held. The cause of the disconnection was the willingness and a lack thereof in others of paying a large premium for a water utility. From this history, we can learn two important lessons. First, the price you pay is naturally important – no different than in the grocery store or at the gas pump. If you’re looking for your investment to track business results, you need the beginning and end multiple to be about the same. It’s hard to make a prudent expectation that a company with single-digit growth ought to routinely trade at 30 or 40 times earnings. This focus on value is important. You don’t have to be perfect, but it helps to be aware. From 2002 to 2014, Aqua America grew earnings by about 8.9% per year – quite similar to the 2005 through 2014 period. The difference was the relative valuation at the time. At the end of 2002, shares were trading around 23 times earnings. As a result, investors saw the share price increase by about 8.6% annually during this period – far greater than the period covered above. The price you pay has a lasting impact on performance. Most of the time it more or less works out, but occasionally investment performance will greatly lead or trail business performance due to investor sentiment. The second thing to take away is that the above example wasn’t the difference between positive and negative results. If you pay 38 times earnings for a company today and next year it’s trading at 22 times earnings, it’d be a reasonable bet that you’re carrying a paper “loss.” Yet over the long term, this doesn’t have to hold. Eventually a strong, profitable business will make up for “overpaying.” Granted you’re still going to trail business results, but you would nonetheless end up with positive performance results; thus the focus on wonderful businesses. Ideally, you’re looking for reasonable valuations throughout, but you can take solace in the fact that owning a collection of strong businesses can help alleviate some of your missteps along the way. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.