In May, the RBA cut the interest rate to an historic low of 2.75%, and all signals are pointing to a lower rate this time next month.
When interest rates drop, potential investors must carefully consider whether they can get better returns from stocks or property and whether the benefit of doing so would outweigh the risks when compared to a standard interest-bearing bank account or term deposit. Being an investor, you begin to learn how and when to trade and, perhaps more importantly, when not to. No stock is a buy at any price.
Back in May this year the S&P/ASX 20 (ASX: XTL) was trading 20% higher than it was in November 2012. That means the market had already reacted to the prices in our top 20 Australian stocks, such as Telstra (ASX: TLS), Commonwealth Bank (ASX: CBA) and Westpac (ASX: WBC). Subsequently in late May and into June, we saw a period of contraction which wiped an average of 8% off the same stocks.
The challenge to investing successfully is finding value in a company before the market does. That is why, when interest rates fall, investors can be exposed to more risk than they may have first thought. Term deposit holders will go in search of high yields and blue chips for safety and, as such, will inflate the prices of some stocks to unreasonable and unsustainable levels. Here are five stocks that stand to benefit from a rate cut in August because they represent value and have high yields.
Retail stocks will stand to benefit from a rate cut because lower interest rates give people more money to spend and should put further downwards pressure on the Aussie dollar, which makes foreign purchases more expensive. Myer (ASX: MYR) and Metcash (ASX: MTS) offer dividends of 7.6% and 7.8% respectively, fully franked.
Sometimes finding a stock that is undervalued can be difficult, but when a company has had a number of bad years thanks to unforeseen cost blowouts, it can be the best time to make a purchase. Leighton Holdings (ASX: LEI) is an undervalued market heavyweight that offers dividends of 4.9% fully franked. According to Morningstar, EPS is expected to increase from a current 133.1 cents per share to 205.1 cents per share in 2015.
Insurance Australia Group (ASX: IAG) came out yesterday and said that it has exceeded previous guidance's of insurance margins and gross written premiums. This is a good company that, in the past, bit off more than it could chew and was thrown out by investors, however currently it represents value for money and pays a stable 3.8% dividend.
Cochlear (ASX: COH) recently released a profit downgrade that hit the company's share price hard. Short-term traders lost sight of the value in the stock. It is the market leader of implantable hearing devices but was forced to cut its profit guidance as a result of customers holding out for the next model rather than purchasing the existing product. At current prices, it will pay a dividend above 3% and is a good play on the AUD/USD exchange rate.
Foolish takeaway
Potential investors should know that investing in the stock market is best done with a long-term window and history has shown that the price of companies, on average, will go up rather than down. Buying good companies is quite easy but no company is a buy at any price. Therefore we try to find undervalued stocks that match the good companies then wait for the eventual increase in price. However while we wait, we should be rewarded with high dividend yields and tax credits.
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Motley Fool contributor Owen Raszkiewicz owns shares in Myer, Cochlear and Metcash.
