Manager Insight

Rising interest rates boost profitability, Tim Caulfield says.
By Diana Cawfield | 09/11/17

Higher interest rates and higher bank profits go hand in hand, says Tim Caulfield, co-manager of Franklin Bissett Canadian Equity. Five of the big banks, led by  Royal Bank of Canada (RY),  The Toronto-Dominion Bank (TD) and  Canadian Imperial Bank of Commerce (CM), are among the top 10 positions in the portfolio.

About the Author
Diana Cawfield is an award-winning writer who has been a regular Morningstar contributor since 2000. Her numerous publication credits include the Toronto Star, Advisor's Edge and Chatelaine, as well as the Canadian Securities Institute's online educational services.

"They're a huge portion of the portfolio because we love those businesses," says Caulfield, "and we like the investment prospects from here. We're not making a macro call on where interest rates are going, but in a rising interest-rate environment, your profitability tends to expand if you're a bank." That's because banks can lend money at higher rates, while the cost of paying interest on deposits doesn't necessarily increase right away, or by as much.

Caulfield is vice-president and director of equity research at Franklin Bissett Investment Management in Calgary. He co-manages the Morningstar Silver-rated fund along with colleague Garey Aitken, using a GARP (growth at a reasonable price) discipline.

Caulfield is mindful that since banks are huge mortgage lenders, they face default risks because of their exposure to the housing market. "We have what could be characterized as an overheated housing market, certainly in some parts of the country," he says, "and that poses potential risk for the banks as far as being mortgage underwriters. There are a lot of people who are spooked about what could happen to the banks in a hard-landing type of scenario."

Despite the more "extreme-type scenarios" of a housing crash, Caulfield believes that if interest rates continue to rise, the banks will experience a soft landing. He envisages a scenario in which bank profitability is rising but with lower loan volumes because people will be less inclined to borrow.

Caulfield says that concern over the housing market offers investment opportunities since it tends to depress the prices of bank stocks. "Effectively they become cheap when investors become more concerned."

The Bissett fund's ample weighting in the banks is consistent with the Bissett managers' tendency to hold on to select core positions for five or 10 years or even longer. "I think the franchises are as strong as they've ever been," says Caulfield. "Perhaps cyclically we are at a peak here with lending and interest rates being where they are, but structurally the businesses look fantastic long-term."

Caulfield's favourable view is based on the fundamental research process at Bissett, which use discounted-cash-flow analysis to determine the value of a business through full market cycles. This is complemented by qualitative research to assess the quality of management and their ability to be good allocators of capital.

Though rising interest rates can boost the financial sector, they tend to weaken profitability in other areas of the market. For example, Caulfield says that sectors like telecommunications services, utilities and real estate tend to be very predictable businesses and therefore they can employ more debt within their capital structures.

For a very long time, he adds, the cost of bearing these debt loads has been fairly cheap for companies in these interest-sensitive sectors. But in a rising interest-rate environment, says Caulfield, "it obviously becomes more expensive to finance your operations if you have a significant amount of debt."

Caulfield says that telecommunications services, utilities and real estate are also examples of sectors where equities pay meaningful dividends as part of the total return for an investor.

In a low interest-rate environment like we're in, he thinks that investors searching for yield can easily overemphasize the dividend component of a stock's total return. "You could be putting too much emphasis on the dividend yield," says Caulfield, "and therefore overpaying for it."

In a rising interest-rate environment, says Caulfield, over-reliance on dividends can become very painful for investors who have been lulled into thinking about investments "from a yield standpoint versus a total- return standpoint."

Looking ahead, "maybe we're in the first inning," says Caulfield, "as far as the potential for rising interest rates, so we want to keep that in mind. I think that investors are a long way from what could ultimately become priced into interest- rate-sensitive equities. That's the advantage of doing the bottom-up work and finding those individual opportunities. It is still very early days."

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