Are You Paying Attention to What the Fed Is Doing?

In this podcast, Motley Fool analyst John Rotonti discusses:

• Why investors should expect more interest rate hikes this year.
• The increasing attractiveness of companies with pricing power and a strong return on invested capital (ROIC).
• Balancing growth stocks with profitable businesses that can self-fund their operations.
• Three stocks John just bought (and why he bought them).

The most rewarding stocks can come from the most boring businesses. Motley Fool analyst Dylan Lewis and Motley Fool contributor Jason Hall make the case for keeping boring businesses in your portfolio and discuss one in particular that Jason's excited about.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on March 24, 2022.

Chris Hill: [MUSIC] We've got a few stocks we bought recently, and they've all got some traits in common. Details next, Motley Fool money starts now. I'm Chris Hill, joined by Motley Fool Senior analyst John Rotonti. Thanks for being here.

John Rotonti: Hi Chris. Thanks for having me.

Chris Hill: I want to talk about interest rates and at the end of yesterday's episode, I promised the dozens of listeners that we were going to talk about interest rates, and we were going to do it in such a way that hopefully, no one is going to fall asleep while we do that. Let me start with this, J. Powell seems extra caffeinated this week. Last week, we had the interest rate hike of a quarter percent. You and I were talking earlier, I was happy to hear that I'm not the only one who's noticed a change in his tone, a change in his demeanor, and we're already talking about future rate hikes to come.

John Rotonti: Yeah, Chris like you said, the Federal Reserve increased interest rates by a quarter of a percentage point last week, and the market reacted positively to it. The Nasdaq went up four days in a row, and I tweeted out last week, just fun the markets playing chicken with the Fed and, sure enough, this week, Fed Chairman Jerome Powell, as well as at least three other Federal Reserve governors, there may have been others, but I've read about at least three others, have basically gone on a pretty aggressive PR campaign, a communications campaign saying that the Federal Reserve is very willing to increase by 50 basis points at one or more future meetings. They're trying to make it very clear that the Fed is committed to getting inflation back down to its long-term target of 2 percent as quickly as they reasonably can.

Chris Hill: I'm glad you mentioned that because there have been a couple of shifting narratives and that's one of them. Just if you think about how collectively investors, the investment community, and the financial media have been approaching the topic of interest rates for months. It was essentially will they or won't they? Are they going to raise rates, or they're not going to raise rates. It really seems like they've moved from that to if you could bet on whether or not they're going to raise interest rates again in the next few months, you should probably bet on that because it seems like a safe bet and we'll get to what investors do in a moment. But as you said, they're being as clear as they can. I just hope that when the time comes and the Fed raises rates a half a percent, nobody comes out and says, well this is shocking.

John Rotonti: Yeah, I mean, Carl Icahn was on CNBC. Billionaire investor, Carl Icahn was on CNBC a couple of days ago and he had this quote and it's almost identical. He said, "Inflation is a terrible thing when it gets going." The problem is that inflation begets inflation and you get sucked into these wage-price spirals a lot of times. Just the same way that disinflation begets disinflation. Which is why for the last 40 years, Chris, interest rates have been falling. For the last 30 years, inflation has been benign and money has been free for most of the time since 2009. All of this could be reversing and at the same time that the Fed put, which is basically a colloquial way of saying that the Federal Reserve puts a floor under stock prices because it's going to come to the aid of the markets. The Fed put is either no longer there or it is set at a much lower strike price. The reason I think that even long-term investors should be aware of what's going on with the Fed and with inflation and with interest rates is because we are at this generational inflection point or regime change or phase shift, whatever you want to call it, we're at an inflection point because like I said, interest rates have been falling for 40 years, inflation has been benign for 30 years, and now it looks like that's about to change.

Chris Hill: I'm processing what you just said because I agree with you. Investors should be aware of what's going on with interest rates. I don't think it's anything investors should obsess over. I mentioned earlier the narrative shifts that are going on. Another one that I'm seeing is the shift among investors away from fear because earlier in this calendar year, it was pretty ugly out there. But I'm seeing a shift away from fear to investors saying, where should I be adding? I've gotten over the fear of the stock market falling, I want to be a net buyer of stocks, which is great, we encourage that at The Motley Fool. When you think about the possibility of this generational shift, how should individual investors process that? By that I mean, should individual investors change the way that they are approaching stocks or even which category of stocks they might be interested in buying.

John Rotonti: I don't know if they changed the way that they approach investing, but maybe just add a little bit more diversity and balance to their portfolio. Then if they are in the type of investor that is more risk-averse, possibly build up a little bit of a cash position even in an inflationary environment like we're in right now with inflation of 7.9 percent. Cash can act as a pretty low-cost hedge, low-cost relative to options and other ways to hedge the market. Cash is still a relatively low-cost hedge. If you're the type of investor that wants to have a little bit extra cushion because the cash can act as a cushion on the way down, and it can provide optionality on the way up if you find a place to invest it intelligently. I think in a high inflationary environment, you want to own companies with some form of pricing power, and that's typically measured through high or stable gross margins. Then you want to own companies with high or rising returns on invested capital. The reason is because, in an inflationary environment, the best businesses to own are those that are not capital intensive or in other words, those that have high returns on invested capital. Because companies that are not capital-intensive don't need to spend a lot of capital investing in maintaining or growing their assets at a time when input costs for those assets are rising. Companies that don't need to spend to maintain those assets, save money basically. That's why Warren Buffett has said any business that requires some net tangible assets to operate is hurt by inflation, but businesses needing less in the way of tangible assets is hurt less. If you just translate that, he's basically saying, own stocking companies that generate high returns on tangible capital. The other area you may want to focus on is real estate. Real estate has historically been a great place during inflation because one, a lot of real estate has long-term contracts with annual pricing power written into the contracts so annually they can increase prices and two, the replacement cost of real estate goes up in an inflationary environment so the input costs go up, so it becomes more expensive to build new real estate. That increases the value of currently existing real estate because it means less new capacity comes onto the market. Those are two areas I would look for companies with high returns on invested capital and pricing power, and then real estate.

Chris Hill: In my own investing life I look at my portfolio. I've said before I have a bunch of stocks that I brilliantly managed to time buying at the peak of the Nasdaq about a year ago. A good number of those are below where I bought them, but my time horizon for them is much longer. I think about those biz. My expectation for those businesses is measured in decades, not in quarters. However, more recently, I don't know about you, but the stocks that I've been buying using that cash position that you mentioned have been the ones that have already proven they can generate a profit. Businesses like Microsoft, Alphabet, just to name two. Because it does seem, you and I were joking about this earlier. It does seem like the analyst community on Wall Street is of the mindset that we're going to punish any profitable company's guidance, because it's not good enough. It doesn't matter that you say you're going to grow your revenue double-digit percent this year. We want it even higher, and I can't be the only investor who looks at some of these large, profitable businesses which are still growing, and take step back and say, "Okay, I get that the growth guidance isn't quite what you're looking for." It's still growth guidance. That's what I'm doing in my own investing life. What about you?

John Rotonti: I agree completely 100 percent, Chris. I lead a portfolio for Showdown, and what I have been telling our members is that look, in this environment, you want to invest across the growth spectrum, meaning own some of those faster growers that are not yet earning a profit, but also earn some more moderate growers, that generate tons of profit and cash flow. So invest across that spectrum. For example, for every Snowflake own a Berkshire Hathaway, for every CrowdStrike own a NextEra, for every Twilio own an Apple. I could go on. For every Asda own an Accenture. It's almost like a one-for-one balance, and that's just a good, I think, sure risk to use in this environment. As far as what I've been buying Chris, as you know, and a lot of our listeners probably know, I don't buy stocks often. I've only bought stocks once this year. That was last week and so I can talk about it now. I added to my position in PayPal around 95. I already had a fairly large position in PayPal I added to that. Then I started a position in KKR and Restoration Hardware (RH -3.37%). All of those companies that I just named, PayPal, KKR, and Restoration Hardware are extremely profitable, moderate mid-teens growers, which is like the types of businesses you and I were just talking about, and they generate a growing stream of free cash flow. That's really where you are ultimately after, especially in inflation, if you can find a company Chris that's growing their free cash flow stream faster than inflation, you're going to do just fine. If you pay a reasonable price and inflation at eight percent. If you can find a company growing faster than eight percent, has got a little bit of pricing power and has good profits, high returns on invested capital. I think you'll do just fine over the long term.

Chris Hill: Many years ago, Starbucks would send out their annual report. It was printed, and there were a couple of years where they included a little something, a little Starbucks gift card that was loaded with five dollars or something like that. Any similar program from Restoration Hardware, did you get any sense that like if you're a shareholder, you get like, I don't know. I'm not saying they're going to send you an $8,000 leather couch, but is there an added perk to being in RH shareholder because that's one of those businesses I've been fascinated by over the years and have never actually bought shares off.

John Rotonti: That's something I should probably know. I don't know if there is an added perk for Restoration. Berkshire gives you an added perk. I think Berkshire, Hathaway shareholders get a discount on GEICO Insurance for example. Yeah, there's an added perk there. Now Restoration Hardware, I have done all joking aside, substantial research on this business. They do have a membership. You can become a member of Restoration Hardware and buy their high-end furniture at a substantial discount, and a lot of their sales do come from their members.

Chris Hill: I'm already covered in terms of insurance, if I buy a share of Berkshire, is there an option? Can they just send me a box of See's Candy instead or something like that? 

John Rotonti: I'm with you, I will take the peanut brittle. I will take the See's Peanut Brittle.

Chris Hill: John Rotonti, great talking to you. Thanks for being here.

John Rotonti: Thank you, Chris.

Chris Hill: John talked about looking for profitable companies with pricing power. Let's go one step further and layer in another business adjective, boring. Let's face it. Some of the more boring businesses can also be some of the more rewarding stocks. With more, here's Dylan Lewis. 

Dylan Lewis: At the Fool, we spend a lot of time looking at the disruptors, the companies that are shaping the future. But sometimes don't have much to show in the present right now. With macro winds switching directions everyday, we thought it might be good to give some love to boring stocks. The companies you don't associate with the cutting-edge, but are driving the present and aren't going anywhere anytime soon. Joining me to talk through it is Jason Hall. Jason, I think just to start, what's a boring stock to you?

Jason Hall: There's a couple of ways to categorize this. But I think in general, there often companies that are either in easily overlooked industries that aren't consumer-facing. It's like the behind the scenes companies or they're just immature industries that don't make it on any investors radars as being growthie or disruptive. They make products that maybe aren't really in the popular consciousness as being excited. But the biggest part of a boring stock is that the company has some durable competitive advantage or advantages that make that boring business excitingly profitable to own.

Dylan Lewis: I think that it's an almost a misnomer to call them boring, because they are exciting, when you look at them from a different lens. But if you're a very aggressive growth minded investor, perhaps they wouldn't necessarily check the boxes for you. I think what we're seeing is there is some uncertainty in the markets and maybe people are looking for some safer places to put cash, is some folks who maybe thought they were a little bit more risk on oriented, being willing to start looking at some of these names, and I think regardless of where you fall on the risk spectrum, it probably is worth at least spending some time thinking about the role that they may play in your portfolio, even if it's not something that you decide you want to add to your portfolio.

Jason Hall: Yeah, I think that's fair. When you think about these kind of boring stocks, I think they can play multiple roles Dylan. As a starting point, one of the things I think that all individual investors can do better is learning how to manage their own behavior and manage how they actually do manage their portfolio. A boring company that generate steady, predictable profits and cash flows. It can really serve to, I'm going to borrow a turner phrase from Andy Cross, our Chief Investment Officer here at the Fool. They can serve as ballast in your portfolio. What that means is as we go through different periods of volatility in the stock. If you own a company that you know is going to be generating predictable cash flow, through pretty much any environment, it makes it much easier as an investor to manage your own behavior and feel less worried about, do I need to sell this company? Maybe interest rates are going up. Do I need to sell this stock? The market's fallen 20 percent in the past few months, do I need to be worried about owning this business, are they at risk? It can be ballast for you. Then that can help you manage your behavior more broadly.

Dylan Lewis: I think it's worth emphasizing here, these aren't necessarily mutually exclusive ideas. You can look for some big names and some indispensable names when we think about the modern economy and say, "Actually, while they've been great performers, they're boring stocks." I would say, just looking at my own portfolio here. I've got Apple, Amazon, Alphabet making up over 20 percent of my portfolio. A large part of that is share price appreciation, but in a lot of ways, those are boring businesses, we know exactly what they're going to be doing day-in, day-out, they're going to be looking for those next chapters. But they have cash cows that are going to continue to fuel all of the innovation that they want to do going forward.

Jason Hall: Yeah, at its core, a boring company doesn't really serve any purpose, it's not helpful. If it doesn't help you reach your financial goals, right, Dylan?

Dylan Lewis: Yeah, exactly. For what it's worth, most of those names over the last 1, 3, 5, 10 years have dramatically outperformed. I think the only carve-out is if you look on some shorter-term, I think maybe one of them, I think maybe Amazon has slightly underperformed the S&P 500. But by and large, those have been some of easiest investments you could've made in tech. They're also pretty darn boring ones. You know the drivers of those businesses. They're very easy to understand and those cash flows coming in are pretty predictable because we know there, so indispensable to the companies they provide their services to, in the case of Microsoft with Azure or the iPhone in your pocket, in the case of a company like Apple.

Jason Hall: Yeah, I think one of the things that's important for some of these boring stocks is understanding the company and seeing where it has a path to grow earnings and cash flows over the long term. Looking beyond the business that might be a little bit boring or not as exciting, Apple as an example. This was a pretty exciting business. We go back 10 or 15 years ago when it was the disruptor, the category creator, in so many ways. But now it is a boring business, but we look at the business. Can you see that clear path to growing earnings and cash flows over the long time. Dylan, I bring that up because that, if you were to pick one factor as an investor that you want to be able to understand about a business that's growing earnings and cash flows, because that is the thing that will lead to share price appreciation over the long term.

Dylan Lewis: I think we've probably lost sight of that a little bit as we've looked at companies over the past five-years because we've been in such a growth oriented market. We have to reflect on that and say, "Well, we're excited about these companies that are growing their top line in a really dramatic way, really excited about this TAM, that they've barely penetrated." Because what does it mean down the road? It means that you're probably going to have a relatively high-margin business with a much larger top-line, and a lot of that's going to flow down to the income, or a lot of it's going to flow down to cash flow for that company, but that's a future state thing, it's not where that company is right now.

Jason Hall: We look at so many of these growth companies that we love that we still appreciate the opportunity. But they are exciting, because of the fact that a lot of them are not profitable yet, and we're banking on that calculus that you were talking about, about taking that more of that total addressable market, maintaining those high margins we see now, and that being future cash flows. But it's predicated on cash flows that don't exist yet. That is where the excitement comes in, and it's the excitement that over the past six months has meant a lot of losses for investors.

Dylan Lewis: I think to remove us from the boring being a pejorative. There's one way to contextualize this into say, how much really has to go right for this company? Are we looking at a business that needs to realize dramatic gains in their market or steel market from incumbents? Or are we generally looking at a business that just needs to continue to light customers and find small growth on top of that. But they're capable of growing just based on what they've already built for themselves.

Jason Hall: That to me is the core of what makes a boring company, a great boring company to own. Whether it's, they're just in the right industries for whatever reason the timing worked out, but they're in a position in their cycle where they are far less susceptible to binary outcomes, or things having to go perfectly, and largely those things are often uncontrollables. There are things that are far outside of management's ability to directly control. They don't have to have everything go swimmingly to workout. They just have to have enough things continue to go the same way they've been going for an extended period of time, and we've seen a track record of being able to do it, and then we again, we find that opportunity based on the trajectory. They're not stuck in this situation where they are banking on somebody else getting it wrong as much as they get it right on their own to be a winner.

Dylan Lewis: I think to bring all that together, Jason, that puts this company in a position to control their destiny a little bit. From a financial perspective, they have the balance sheet to be able to do whatever it is that they'd like to do that can allocate capital opportunistically as they have interesting opportunities in front of them. But they're not going to be beholden to the short-term wins, if anything. That's what makes them particularly attractive. They can, weather these markets and actually aggressively invest in spaces, maybe when things are not going particularly well, and a lot of other disruptors have to pull back some of their spend.

Jason Hall: Two of the most powerful ways a company can have control of its own destiny is number 1, being in a business that generates positive cash flows, makes earnings, and having a balance sheet that is a source of strength. In both of those situations, you're not relying on the generosity of others. You don't rely on the capital markets to secondary offering to raise capital, especially when your stock prices depress. You're not having to talk to your banker with your hat in your hand to try to get some funds at a reasonable rate to invest in growth. There are few things better than a strong balance sheet and having good cash flows.

Dylan Lewis: These are things that we generally emphasize in businesses that we look at, even if they are high-growth businesses,. We do that check when we're looking at high-growth software company that's not necessarily profitable right now and say, "Okay, what does their cash coverage look like on their debt?" Doesn't mean that it's necessarily going to be something that categorically rules them out as investment, but you have to note it and understand it. These are just businesses that happened to have that across-the-board in terms of strengths. We've talked about some names that I think a lot of people are probably familiar with, own it directly or indirectly by way of a mutual fund with some of those big tech names. But I do want to highlight especially some of these lesser followed industry names that fit the boring company categorization, Jason.

Jason Hall: When they comes to mind immediately when we started talking about this particular subject, is a company called Trex Company, ticker TREX. Dylan, I don't know about you, but I get really excited about decking. I'm also in my mid-40s, I have a house. That makes me part of a very small niche of group that actually get excited about decking and lumber materials. Trex', this is their core business. They make decking. It's a green product, it's 95 percent post-industrial or consumer plastic or would waste. They make a renewable product. But very few people get excited about this. But it's an industry leader, as they've had this very strong established market position. Their distribution is a competitive advantage. Their full integration with manufacturing, they have a significant cost advantages. Right now, when the lumber industry is dealing with some of the highest prices for lumber we've seen in decades, this company is buying up all the scrap and has waste plastic that's part of the waste stream that a lot of companies will just about giveaway because there's no economic value. They have that feedstock and their manufacturing process that gives them some very real durable competitive advantages. It shows up on the bottom line, this is one that's not boring for me, 340 percent in total returns over the past five years. That's about four times the S&P 500 over the same period.

Dylan Lewis: Yeah, and a company that has bit a little bit by the recent pullback we've seen in some names. It's in some ways a boring company and in some ways one that had some growth priced into it. But it's not like a business that's going to be replaced by any competition anytime soon.

Jason Hall: Yeah, this is a company that commands about half of its market share against companies that make a similar product. When you compare it against all of the decking including wood, which is the real dominant market share. There is still about 85 percent of the market out there that it has the ability to go after. I would say that as much as we've seen in the sell-off on growth that was priced in. It's a seasonal business too. In the winter, we've shifted from its slowest period where it's building inventory at spending more money and selling less decking into now, which is really when it's busy season kicks in, so I think there's a certain amount of seasonality of the business that people don't understand. But again, that balance sheet and those cash flows. Men, this is just a wonderful company most people won't get excited about.

Dylan Lewis: I like that you own. That was one that you would be excited about though, because I think boring is to some extent in the eye of the beholder, and really, it doesn't matter where you land on whether some of these maybe less sexy businesses belong in your portfolio or not. It's really helpful to take this approach and look at what you do own and just make sure that your expectations are aligned with what's in your portfolio. 

Chris Hill: That's all for today, becoming up tomorrow, we've got some predictions for the upcoming academy awards. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.