Preparing for Economic Growth and Rising Interest Rates

Nihar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Brighter economic times are ahead, but as the economy rebounds it will probably be necessary for interest rates to rise to keep a lid on inflation. This will be a very gradual process, but it is as close to a sure thing as possible. As long as you keep that in mind, certain investments that seem out of style at the moment become solid long-term choices.

Starting with insurance

Superficially, insurance is simple. The company takes money in and generates a return on it. The hope is that the payouts it has to make are small compared to its premiums and investment returns. The general rule is that higher interest rates help the company generate higher returns. Not all of the money goes into high-risk investments like stocks, though insurance companies are pushed into riskier investments if safe investments yield next to nothing.

MetLife (NYSE: MET) caught my eye for a handful of reasons. I usually prefer using the trailing price-to-earnings ratio, but since I am focused on where the company sees itself going I looked at forward ratio instead. It stands a little above 8, which is not bad. It used to be lower, but MetLife has seen its stock prices rise since mid-April. The other thing is that it trades below book. This is not something that creates a positive outlook, but being below book provides the stock with some downside resilience. The company is trudging along nicely with impressive 11% revenue growth year-over-year in the last quarter.

I am more interested in what is going to happen in 2014 and 2015. With the forward price-to-earnings ratio as low as it is, I think the current entry point is acceptable. Had I paid more attention to the company two months ago then I would take a bigger position. As it stands, the company has seen an impressive run so I would split my strategy between buying a position and selling puts at $42 to $43. The rest of the company's fundamentals seem good enough with ample cash and debt under control. There is also a dividend yielding over 2% so it would not be awful to hold if you believe the long-term story.

Mixed bag for mREITs

Annaly Capital Management (NYSE: NLY) will not have it easy if interest rates drift upwards. It will put a downward pressure on its book value, but I think there is a strong possibility that the spread between long-term and short-term interest rates will increase. That can lead to more money for Annaly. It might be a shock to see the book value decline, but I would hope that the gains in income offset that shock. As the company makes more money it might be able to bolster its dividend, which has lost a lot of its luster.

Interest rates will not reach high levels in a day. It will be a slow process, so you will have time to evaluate it if the spread increases. Annaly is a dividend investment, and if the company can make more money it should be able to increase its dividend. You want insulation from any shock drops resulting from interest rate hikes, which means getting the stock as cheap as possible. I would only take a small position until the first interest rate hike, but I would not be opposed to sitting at $8 to $9 with puts for a drop. At that price the dividend would also be attractive.

It is very much a waiting game with Annaly, but the company uses more conservative practices than some of its peers. It recently acquired CreXus, allowing it to diversify with commercial paper. I generally like diversity, even if it does not add as much to the bottom line as I would like.

Will aluminum ever recover?

I do not want to be wrong about Alcoa (NYSE: AA) forever. I would have expected aluminum to bounce back some, but it remains at its massively depressed level. Alcoa is down to around $8, but there is no end to the negative outlook in sight.

If the global economy really does improve, I would like to think that Alcoa has the chance to see higher share prices again. If aluminum prices rise, I would not be surprised to see a relief rally in the stock. You cannot take a position in the stock until the picture becomes clearer, however. The company's recent conference call showed that it is doing well managing expenses and generating as much income as possible, but there is no growth to be had. I would buy it under $5 on speculation, though nothing suggests that it will go that low yet.

On the first sign that aluminum prices are recovering, I would take a real position in Alcoa. The company has managed to keep its head above water, and despite the increasingly bleak metal environment it is not overly saddled with debt. It also has enough cash on the balance sheet to keep moving forward.

I want to see Alcoa use this time effectively, and it has been cutting costs where possible. I still maintain that when things do get better it will be great news for Alcoa. I would wait on the company, but it is worth grabbing if it gets really cheap.

Conclusion

Things are getting better, which is always hard to see when things have been so bad for so long. The calamity that was the financial crisis left many shaken. Interest rates will eventually rise and a new boom cycle will begin, leading the Fed to shift to preventing the economy from overheating.

In that environment, a company like MetLife can boost its returns since its fundamentals tell an interesting long-term story. On the other hand, interest rates are a double-edged sword for a company like Annaly. Since it is a dividend investment, Annaly is worth getting as long as you can get it cheap.

Alcoa is an avoid unless you want to speculate when it is far cheaper. The earnings conference call should give you some idea into what the company’s expectation is.

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Nihar Patel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

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