Stocks to Avoid While The Fed Keeps Rates Flat
Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
So the Federal Reserve reconfirmed that it intends to keep interest rates at historically low levels for the foreseeable future. Low rates are good if you are borrowing money, but aren't so great if you are lending money. This will continue to hinder the businesses of companies with rate related businesses.
What is this thing called “Float?”
Automatic Data Processing (NYSE: ADP) has an incredible business model. The company handles payroll processing for large corporations using its own internal systems. Thus, adding a new customer has some upfront costs, but costs virtually nothing once the customer is set up. That's a material amount of leverage. Moreover, customers don't like to switch payroll providers because of the hassle involved. So ADP's business tends to produce annuity like income streams.
The best part of the business, however, is probably “the float.” In order for ADP to process a payroll it must receive money from its business customers prior to sending any money to its customers' employees. That means that ADP usually has a large cash balance sitting around for a up to a few days before it is scheduled to get pushed out the door as payroll checks. While ADP doesn't own the money, it controls it. That money sitting around is “the float.”
Other People's Money
Since ADP controls that money, it can put it to work by investing it. While the payroll processor could invest the cash in the stock or bond markets, such investments carry material risks. Since ADP will have to make up any capital shortfalls, it clearly doesn't want to take on market risk. So, instead, it invests in short term investments that are, for the most part, 100% safe. Such investments tend to key off of the prevailing interest rate, which is currently so close to zero that ADP isn't making much money off “the float.”
Add in the slow economy, and a once robust business isn't looking quite as good. That goes doubly for ADP's competitor Paychex (NASDAQ: PAYX). The float is a material part of Paychex' business, too, but this company's focus is on small- and mid-size businesses. Since smaller companies have been hit harder by the recession and slow recovery, Paychex's business has suffered much more than ADP's. Both companies are trying to branch out into additional areas, most notably human resource functions, but these efforts simply can't make up for the double whammy of a slow economy and the virtual complete loss of income from “the float.”
Not “Float”, But Just As Important
The Insurance industry is another area that feels the pinch of low interest rates for a similar reason. While insurance companies don't have “float,” they do receive money today for services that may be provided tomorrow if something “bad” happens. So while the accounting underpinning the insurance industry is very complex, the basic business model in the space is pretty simple: Take money from customers for the promise of insurance overage and invest that money profitably over time.
Indeed, insurance companies make a great deal of money by investing the premiums they receive up front. In fact, there are times when insurance companies are willing to lose money on an insurance policy just to get money to invest. While there is clearly more going on at an insurance company than this simplification, a quick look at the long-term success of Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) is, perhaps, the perfect example. The so-called oracle of Omaha basically uses the insurance shell to fund his company's stock investments.
This has worked out quite well for Buffett and Berkshire shareholders, and it has also worked out well for some other large insurers over the long-term. That said, it helps explain why the performance of the stock and bond markets is so important in the insurance industry.
However, insurance giant Prudential (NYSE: PRU) recently cut its expectations for long-term stock market and bond market returns by over a full percentage point. That's a huge statement and one that has a massive impact on an insurer's business. A big part of the problem is the Fed's move to keep interest rates low.
Interest rates are also important for Federated Investors (NYSE: FII), one of the largest money market fund managers. The company provides money market management services for other companies, but with rates so low, the expenses of managing these funds eats up more than the fund makes from their investments. This is clearly bad for Federated in that it has to give fee reductions to keep its money market funds viable. Moreover, with such low rates, investors haven't been inclined to park their cash in a money market fund at all, meaning that Federated also has less assets under management.
Just A Few Examples
These are just three examples of companies and industries that are suffering because of low interest rates. Banks are also finding low rates a problem, though they also have numerous other issues to deal with. While economic growth is important, the consequences of the Fed's policy decisions are far more complex than many realize. In that, however, could be an investment opportunity. For example, when rates go back up, ADP, Paychex, and Federated are all likely to see earnings rebound smartly. Keep them on your radar screen.
ReubenGBrewer has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway, Federated Investors, and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!