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I'm not much of a macro trends guy, and I'm certainly no market timer. But with interest rates still sitting near historic lows even as the money supply expands and the economy grows, this seems like a good time to add to our watchlist some stocks poised to profit if interest rates rise. Here are three companies I'll be keeping my eye on.
Automatic Data Processing
If you've held a job sometime in the past decade, there's a solid chance that Automatic Data Processing (Nasdaq: ADP ) has processed your paycheck. The company handles payroll and other human resources functions for about 520,000 employers with more than 600,000 payrolls. But the intricacies of ADP's business are not the reason for my interest today; instead, I'm eyeing the $32 billion in funds the company holds for its clients. ADP takes funds from its clients, then turns around and pays its clients' employees and the relevant tax authorities. There is a time delay, though, between when ADP receives the cash from its clients and when it has to hand it over to its end recipient. During that time, ADP earns interest on those funds.
ADP's client funds balance has rebounded strongly over the past year, up more than 70% from $18.8 billion last summer, thanks to wage growth and early signs of a rebound in employment. But all that money is still earning low interest rates -- just 3.6% last year. If interest rates rise, ADP will begin raking in gobs more effort-free cash.
If you read the previous paragraph, here's a one-line explanation of Paychex (Nasdaq: PAYX ) : It's the Automatic Data Processing of small businesses. While ADP focuses more on the 1% of companies that employ more than 100 people, Paychex rules among smaller players; 82% of its clients have fewer than 20 employees. The client funds it holds, however, work just as those with ADP. Paychex's client funds balance current sits at $4.2 billion, which is much lower than at ADP, but Paychex is a much smaller company. And just as for ADP, rising interest rates mean higher income for Paychex without lifting a finger.
Often described as a miniature Berkshire Hathaway (NYSE: BRK-B ) , small-town Virginia-based Markel (NYSE: MKL ) is a specialty insurer with a Buffett-like penchant for allocating capital to non-insurance investments. Like Berkshire, Markel invests the float from its insurance operations -- the money the company gets to hold between collecting premiums and paying out claims -- in both a publicly traded equity portfolio and a growing suite of wholly owned private businesses.
How would rising interest rates help Markel? There are two pools of investment for the company. First, Markel invests enough to cover its expected claims in liquid, cash-like investments (such as money market funds and Treasuries). The remainder is allocated to more interesting, outsized-return seeking investments in stocks and private businesses. As interest rates rise, less capital needs to be invested in the former cash equivalents category to meet expected claim payments, meaning that more funds can be devoted to the value-creating investments in the latter category. And Markel Chief Investment Officer Tom Gayner is seeing no shortage of investment ideas. Two weekends ago at the annual Markel breakfast in Omaha, I heard him tell a roomful of shareholders that he has "more ideas than money."
What's on your watchlist?
I don't know when higher interest rates will arrive, but I want to ensure I am poised to profit when they do. That's why these three stocks are making my watchlist today. If you'd like to stay tuned to learn if I decide to put real money behind any of these ideas, you can follow along on Twitter.
To add any of these stocks to your watchlist, just click on the links below:
- Add Automatic Data Processing to My Watchlist.
- Add Paychex to My Watchlist.
- Add Markel to My Watchlist.
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here.