The prospect of rising interest rates is bad news for growth stocks like Class Ltd (ASX: CL1) and REA Group Limited (ASX: REA), as well as defensive stocks like Sydney Airport Holdings Ltd (ASX: SYD) and Westfield Corp Ltd (ASX: WFD).
However, it could be good news for financial stocks that would benefit from a rising interest rate. It may benefit banks like Bank of Queensland Limited (ASX: BOQ) and Bendigo and Adelaide Bank Ltd (ASX: BEN), but big banks like these and others may have their own problems in the coming years.
The two financial companies below could benefit fairly substantially from the interest rate changes without the potential need to issue more shares like the big banks:
Mortgage Choice Limited (ASX: MOC)
Mortgage Choice is one of Australia's largest independent loan brokers with a market capitalisation of $277 million. It earns a vast majority of its income from loan brokerage, but is slowly diversifying its earnings. In FY15, 90.6% of revenue was from brokerage and in FY16 this reduced to 89.5%. Most of the diversification of revenue was from an increase in its financial planning division.
It had a pleasing FY16 as it increased cash earnings per share by 10% and dividends per share by 6.5%.
A big part of what will improve Mortgage Choice's prospects is the usage of brokers for new loans. In March 2014 around 50% of Australian loans were done through a broker, in March 2015 it was 51.9% and in March 2016 it was 53.7%. This is a very pleasing trend for Mortgage Choice shareholders.
But it also requires Mortgage Choice to maintain or grow its market share of the broker market. In the second half of FY15 its market share was 3.6%, in the first half of FY16 it was 3.65% and in the second half of FY16 it was 3.76%, another pleasing trend for shareholders.
Even if interest rates weren't to change, Mortgage Choice is heading in the right direction. However, if interest rates do change there may be a lot of churn from mortgage holders changing to a better loan than the one they are currently in. As Mortgage Choice is receiving more commission from new loans, this could be a sizable boost to profit.
Mortgage Choice is trading with a price/earnings ratio of 14.2 and a grossed up dividend yield of 10.57%.
Challenger is Australia's leading provider of annuities to people seeking reliable income products and it has a market capitalisation of $6.3 billion.
It has large tailwinds as a large number of baby boomers hit retirement age increases and they want to convert their capital into a secure income source. Challenger puts a lot of this money into fixed interest products and the rest into higher growth options like shares and property to hopefully make the capital work harder.
In the second half of FY16 Challenger grew its annuity sales by 45% over the prior corresponding period. This is very impressive growth considering the level of sales Challenger was already achieving.
If the interest rates do rise, Challenger would be able to offer annuities with higher rates of return for the retiree which would make them more attractive and therefore potentially attract more annuity sales.
Challenger is trading at 16.8x FY17's estimated earnings with a grossed up dividend yield of 4.21%.
Foolish takeaway
A large percentage of businesses' share prices may be affected negatively over the next few months due to a re-rating of what investors are willing to pay for 'riskier' assets like shares.
However, there's a good chance that Challenger and Mortgage Choice would be able to increase their revenue and profits from this change which could increase their share prices in the medium term. I think both businesses look like a decent buy at these prices, but by next week they may look cheaper and even more attractive.
