5 value stocks to profit from rising bond yields

Ever since Donald Trump became President elect of the US the yields on government debt have started to rise in response to the prospect of higher cash rates across the globe.

One notable consequence for Australian investors is the sell off in growth stocks as expectation and valuations are adjusted to reflect an increase in the discount rates analysts commonly use to value these businesses in their simple discounted cash flow valuations.

Stocks (like other assets including bonds) are valued as a function of their estimated future cash flows relative to the time weighted value of money and the adjusted risk of investing in businesses (that could go bust) compared to US government debt for example, which is considered the benchmark risk-free rate.

A greater discount rate being applied (in expectation of better risk-free 10-year returns) means stocks with longer and more aggressive cash flow growth expectations baked into their valuations are likely to be valued less highly.

Recently highly-valued stocks like Cochlear Ltd (ASX: COH), Transurban Group (ASX: TCL) and Bellamy’s Australia Ltd (ASX: BAL) have all fallen partly in response to investors’ expectations for a changing risk-free rate environment.

So if it’s game over for growth stocks investors may be better off looking to value stocks that will benefit from a higher cash rate environment going forward.

Below, I have some to watch in 2017.

Computershare Limited (ASX: CPU) is the share registry business that invests funds it holds on behalf of clients in exactly the sort of low-risk debt markets that will offer far better returns if US fiscal and monetary policy changes direction in 2017 and beyond. The shares are up 13% over the last week and selling for $11.64 may still offer reasonable long-term value.

QBE Insurance Group Ltd (ASX: QBE). I’m no fan of this business but am not surprised to see it up 10% since the election of Mr. Trump given his eagerness to wean the US off ZIRP or zero interest rate policy. The estimated forward price-to-earnings ratio is around 16, shares sell for $10.70 and I expect QBE may have a strong 2017.

Insurance Australia Group Ltd (ASX: IAG) is another insurer that may find more investor support ahead given it invests its premiums in the kind of money market and longer dated debt instruments that are likely to provide better returns in the years ahead. Shares sell for $5.35 on a yield of more than 5% according to analysts’ expectations and for dividend seekers it looks a reasonable bet.

Challenger Ltd (ASX: CGF). Trades on an estimated forward price-to-earnings ratio of 17 and enjoys a dominant competitive position and some powerful tailwinds as a provider of annuities mainly to Australian retirees. The stock sells for $10.50 and given the valuation it looks a buy in my opinion.

Macquarie Group Ltd (ASX: MQG) is another business that offers decent leverage to a stronger U.S. dollar while its valuation is unlikely to be revised lower as assumptions around its future cash flow growth will be relatively modest compared to other technology or industrial stocks for example. The potential repeal of some of The Dodd Frank Act in the US may also lighten its operational risk and general compliance costs. Given the reasonable valuation it also may outperform its more highly valued rivals in tomorrow’s ZIRP free world.

Of the companies above I remain keen on Challenger, although I would not be surprised to see all of them outperform the market in 2017.

However, the only two I would seriously consider buying at today’s valuations are Challenger or Macquarie. Investors solely focused on income could do a lot worse than buying IAG shares, with Computershare’s mixed track record recently meaning it remains one for the watch list.

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Motley Fool contributor Tom Richardson owns shares of Bellamy's Australia, Challenger Limited, Cochlear Ltd., and Macquarie Group Limited.

You can find him on Twitter @tommyr345

The Motley Fool Australia owns shares of Bellamy's Australia. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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