The Rate Hike Wall Street Expected

In this Motley Fool Money podcast, Motley Fool Chief Investment Officer Andy Cross discusses:

• The Fed's latest 0.25 percentage point rate hike.
• The unfortunate timing that had Fed Chairman Jerome Powell's press conference and Treasury Secretary Janet Yellen's public testimony before Congress occurring simultaneously.
• Why he's going to be paying more attention to annual reports in the coming weeks.

And Motley Fool analysts Nick Sciple and Jim Gillies face off in the semifinals of our stock market madness investing bracket!

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 23, 2023.

Chris Hill: It's rare that we offer unsolicited advice to the good people on Capitol Hill, but today is just one of those days. Motley Fool Money starts now. I'm Chris Hill. As promised, joining me today, the Chief Investment Officer Andy Cross. Thanks for being here.

Andy Cross: Chris, thanks for having me.

Chris Hill: We got the quarter-percent rate hike on Wednesday afternoon. This went as expected in terms of the rate hike and the language around it. When you look at the reaction on Wall Street and the investing community today, things seem good. I hate to generalize like that, but just in the moment, this seems OK. This went as expected and the market is reacting positively.

Andy Cross: Well, I think if you have the chairman of the Federal Reserve, Chris, and the secretary of the Treasury testifying or giving comments at the same time on an announcement when they raise interest rates, I think most people would probably qualify or categorize that as, that's pretty unusual. That's what we had yesterday, Chris, and the markets did not react nearly as positively today because, I think, of the dual hit between an increase in interest rates and continued tough talk by Chairman Powell about making sure that the markets understand his commitment and the FOMC's commitment to fighting inflation with higher interest rates.

At the same time, yet, you had Secretary of the Treasury Yellen testifying on the Hill that there's no plans yet to have blanket coverage for all depositors, so that continued to put pressure on the bank stocks.

Today, you have a little bit of a different story, Chris, I think, as the markets are coming to terms with, OK, we do have higher interest rates than we had the day before. That was expected. 25 basis points, as you mentioned, was pretty baked into the markets, and now just continued thinking that wow, with tighter financial conditions that are likely to come from the banking crisis that we're experiencing, that might mean the Fed does not have to be as aggressive raising rates, and so down the line, interest rates in the marketplace may be a little bit not as high as they are today, and that's got the stock market excited to be investing.

Chris Hill: We're not all that interested in politics, and we don't inject ourselves in political things, but on behalf of investors everywhere, I'm just going to say to anyone listening who currently works in the U.S. House of Representatives or the United States Senate: In the future, please don't schedule the secretary of the Treasury, whoever it may be at that time, to testify at a public hearing the same time the head of the Federal Reserve, whoever that may be at the time, is giving a press conference after the Fed meeting. Because the Fed meeting -- this was on the books. This was known months in advance. We knew when this was going to be, so come on. Come on, people on Capitol Hill scheduling these things with the Treasury secretary, do better in the future -- just do better.

Andy Cross: A little scheduling snafu, I would say... I don't know. Obviously, the chairman and the secretary had been in, I would imagine, daily conversations over the past three weeks since the Silicon Valley Bank situation and the other banks closing down, so I can't imagine they didn't know each other was testifying, but still, a little bit of a scheduling challenge. But, all jokes aside on that, I think what we're seeing now, Chris, is this reaction in the marketplace that Chairman Powell clearly knows about the banking industry and talked a lot about that yesterday in his 45-minute press conference -- came out and said that this situation is going to make financial conditions tighter. Right now, the data, he said, doesn't really necessarily show that the financial conditions are tightening so much, but he admitted, he said that's backward thinking and some of it hasn't caught up yet.

I think he's expecting, or at least the market is expecting, those conditions are going to tighten, and that might mean that the Fed is not going to be nearly as aggressive as maybe they were expecting or intended to do before the banking crisis started, and that will mean they don't have to be as aggressive on interest rates. Of course, lower interest rates -- and the market continues to price in cuts later this year, in expectations that the Fed will have to pivot. And lower interest rates -- that's good for stocks, especially technology stocks. And Chris, finally, I'll just note that the NASDAQ-100 is almost up 20%, probably is up 20% now, as of today from its lows last fall. Now, it's still down 15% from its highs, but it's up 20% from the fall. So there's a lot of continued enthusiasm to be buying some of the larger-cap growth and tech stocks in the marketplace in 2023.

Chris Hill: You and I were talking about this earlier today. We've been at this a year now. If you go back to March of 2022, we've had, I believe this is the ninth rate hike. What is your nervousness level? Keeping in mind that you and I and every other investor in the United States, and probably around the world, our nervousness level is made higher by, as you called it, the Silicon Valley Bank situation, which then extended to First Republic, Credit Suisse, and potentially others.

Andy Cross: Not to make light of Silicon Valley Bank, and I've written a lot about this, and we've written a lot about that, and the still-unfolding crisis that that kicked off.

I'll say, Chris: You look at the data. There's obviously continued worries that the United States, if it's not in a recession now, will be in a recession. Although I will note that the Atlanta [Fed's] GDPNow forecast still has us for growth over the next year, but concerns about the recession. For the investing side, when we start to see those recession fears really kick in, and we start to see market nervousness in place, you start to see maybe some capitulation. That's ultimately good for long-term investors like ourselves. And sometimes, as hard as it is to be investing through those most difficult times, that's the best time to be a long-term investor.

I don't think we're quite there yet. I still think, as you said, my nervousness, twitching, is still where it was at the beginning of the year, just for now, just different circumstances. The banking situation especially just depends on what happens with some of the local regional banks -- especially because they provide so much funding for commercial real estate loans. Banks that are less than $250 billion in assets -- and anything above is a fairly large bank -- but those less than $250 billion in assets account for 70% to 80% of commercial real estate lending in the United States. So there are still concerns around just the liquidity and the credit cycle going forward in this banking crisis, and what's going to continue to come from it.

But from an investing perspective, when I look out 3 to 5 years, interest rates -- at some point, the inflation curve starts to improve. The interest rate curve starts to flatten a little bit, get back to normal as the market comes to terms with where the Fed wants to be and the Fed comes to terms with where the market wants to be. I think when I look out long term, I still see a higher terminal rate than we had in the last five years, and that's going to continue to put pressure on valuations. But the best businesses that are going to continue to grow, you can buy and own those at good prices throughout the next 6 to 9 months, and I think long-term investors will end up benefiting from that come 2025, 2026, and beyond.

Chris Hill: What are you going to be watching over the next month or two, keeping in mind, we're basically at the end of this most recent earnings season cycle? We're going to have a couple of quiet weeks, at least on the earnings front, before things start picking up again in the second half of April. What are you going to be watching to give you a sense of where these stories are going next?

Andy Cross: Well, I think the thing, Chris, that we'll be doing is, we're already starting to see a lot of the annual reports and the 10-Ks come through. There's a lot of excitement, a lot of interest and curiosity, and a little bit of fear around ChatGPT and how that is impacting business models, so I'm excited to compare different annual reports from last year to this year to see which companies are talking more about that. Clearly, so much of the conversation is going to be around the banking crisis, and liquidity issues, and understanding what the Treasury Department and the Federal Reserve and the FDIC are doing to protect depositors.

Blanket protection of all depositors requires an act of Congress, and I just don't know if they'll be able to do that or do that soon. So we'll see how the banking industry continues to react to the changing dynamics, especially if interest rates stay elevated and bank balance sheets stay a little under pressure relative to what some of their assets were worth a year-and-a-half ago, and how the market digests that news. So those things, from the analyst side, it's really digging into a lot of the annual reports. From an observer side, I continue to watch what's happening at the Treasury Department, and especially in the small regional banks. 

Chris Hill: Andy Cross, always great talking to you. Thanks for being here.

Andy Cross: Thanks, Chris.

...

Chris Hill: Up next, we've got our second semifinal matchup in our investing version of March Madness, and you get to pick who advances to the finals. After this episode, vote for the analyst that you think made the stronger pitch in our Twitter poll -- @MotleyFoolMoney is to handle to look for on Twitter. Today, it's Nick Sciple facing off against Jim Gillies.

Rick Mulvey: We have our second semifinal matchup for stock market madness. Nick Sciple and Jim Gillies returning. Nick has a nuclear energy technology stock. Jim, you've got a home brokerage stock or a real estate brokerage company. The way this is going to work is Nick's going to have 2 minutes to recap his stock. Jim is going to have 5 minutes to recap his stock and offer a rebuttal. Then Nick gets to finish it off with a 3-minute rebuttal. With that, we will get started. Nick Sciple, you've got 2 minutes to recap BWXT Technology.

Nick Sciple: Friends, great to be back here. I am Nick Sciple. As Ricky mentioned, my company is BWX Technologies. BWX, if you might've heard on a previous episode, is a provider of nuclear components and services to the defense industries, the commercial power industries, and the healthcare industries. In the defense business, they are a monopoly provider -- and have been for longer than I've been alive -- of nuclear naval propulsion systems for aircraft carriers and submarines for the U.S. Navy. There's new opportunities opening up in advanced microreactors and also exporting of nuclear defense technologies to countries like Australia. And the commercial side of the business is really benefiting from upswings in demand from nuclear power, particularly small modular reactors, where they are partnered with EGE Hitachi, that now has the leading design on the market. It's going to be the first one deployed in North America, it also has a long-term trajectory toward deployment with the TVA in the U.S.

Then also, the healthcare side of the business is set to really start producing for the company. It's been a drag on capital for the past several years, but they've got their nuclear isotope reactor design up and running. Now that is ready to be approved by the FDA and it's going to start producing cash for the business. So you're going to see free cash flow increase fourfold in 2023 from where it ended 2022, from about $50 million last year to $200 million this year. Tailwinds behind all parts of the business. Free cash flow about to swing up in a meaningful way, and a long-term plan to return 50% or more of free cash flow to shareholders. That's why I like the stock, and why I think BWX Technologies is a company that can do very well in March Madness.

Rick Mulvey: Nick Sciple, thank you for the recap. Jim Gillies, you've got RE/MAX, and you've got 5 minutes to do whatever you want.

Jim Gillies: My company is RE/MAX. They are a franchisor of real estate brokerages and to a lesser extent, mortgage loan origination brokerages under the Motto Mortgage brand. They buck the mold in terms of the traditional broker-agent relationship. That is, most of the time, a traditional broker will take 25%, 30%, 35% of an agent's commission in a real estate transaction. RE/MAX gives its franchisees, they have what I call an agent-favorable commission split where the agent keeps 95% of the commission and the broker takes just about 5%. They also are taking monthly fees and annual fees, as well as various fee-based things that franchisors like to take. But what this little secret sauce does is, it's a powerful incentive for the best of the best agents to gravitate toward a RE/MAX banner because they can bet on themselves.

For an example of how this works, they publish every year a table in their annual report showing the average number of transactions for RE/MAX agents. It was 16.5 in 2021. And for competitor agents or competitor banners, the average agent does about 7.6 transactions as  of the most recent one of these graphs. This variance has been there for years. So we have some very definitive evidence that this special agent-friendly model works. But of course, as a franchisor, we're very happy to get the annual dues per agent, the fixed fees per agent, the broker fees -- that's the 5% -- franchise sales, and monthly fees from the Motto offices. The financial picture is obscured a little bit by the fact that there is a dual-class share structure here. But right now, the macro winds of the real estate industry are such that after a real gung ho 2021, 2022 fell into disrepair. A lot of real estate companies are down significantly.

RE/MAX is no exception because number of transactions has fallen off significantly. I think that smells like opportunity to me if you have the requisite long-term viewpoint here. You actually have, to start with ... you've got founding management still here on the board. The former CEO is on the board. It's a husband-and-wife team who for about 7 or 8 years in this public company's history took no salary, bonus, or other comp -- they just got paid in dividends on their dual-share class structure. They own about 41% of the total enterprise because the company has been both paying a very attractive dividend -- about 5.3% today -- as well as buying back their own stock at this very nice low valuation. Share price is basically the lowest it's been in its public history, aside from the brief period at the start of the pandemic.

Valuation, we're trading about 7 times this year's expected EBITDA, 14 times this year's trailing free cash flow. We know that they are buying back a significant amount of shares at this present price. Basically, it's not a sexy business. I'll grant you that. But we are going to see houses bought and sold this year. We see houses bought and sold in every market, regardless of whether it's a hot market or not. I don't think it's going to be terribly hot for a while. But that's OK because it gives them a chance to buy in a significant portion of the shares as well as you get paid 5.3% to wait.

Now, while of course, I like my stock better than Nick's, I have to say it's only slightly more than Nick's, because what most folks might not realize is that both of these companies are recommendations in the service I lead and the one that Nick contributes to significantly -- both our recommendations are in Hidden Gems Canada, I can feel like I truly can't lose here. But my concern about BWXT -- which I do like and I have an office actually within about a 20-minute drive of me that way -- what I am a little concerned about is, a lot of their success is tied to government contracts, governments standing up and doing stuff. I just have a long history of thinking, well, when the government says they're going to do X, Y, or Z, in whatever time frame, it generally takes two or three or four times as long time frame-wise. It's always pushing it off, a bit of a Waiting for Godot thing. That's my major knock on BWXT as an investment, because it would change what the valuation is you're paying now because some of the goodness, I think, is going to come a few years from now. But frankly, that's pretty light sauce. So other than that, I think these are two excellent companies for Fools to consider.

Rick Mulvey: Light sauce from Jim Gillies. Nick Sciple, you've got 3 minutes to offer whatever sauce you want.

Nick Sciple: Sure, maybe we'll make it a little bit spicier. As Jim said, both these companies are in Hidden Gems Canada. I think both of them have strong prospects going forward. Now, why should BWXT survive and advance, and the RE/MAX folks go home? I think if you look in the NCAA tournament, you really need to have multiple ways to win. You need to be able to have your best player maybe not have the best game, and still be able to grind your way through. I think BWX Technologies has a few more ways to win than RE/MAX. You mentioned the defense business, the nuclear subs, and as well as services servicing NASA and DARPA, and some of these other military agencies. We also can win through increased growth in the commercial side of the business.

We also can win by becoming the sole supplier of some really key medical isotopes to North America. As Jim laid out for RE/MAX, what you need for this company to win is transactions to turn up in the real estate business. There is going to be a steady-state number of transactions in the real estate business -- frictional, people moving from job to job, or that sort of thing. But given the current state of the market and mortgage rates, I think it's fair to say -- and Jim laid this out -- that RE/MAX is going to be beholden to the macroeconomy for a period of time. Another thing, there are some differences between these two companies. As I laid out, BWX Technologies is a monopolist in many of the areas of the market that it serves. There's lots of other real estate brokerages out there doing a similar thing to what RE/MAX does.

As Jim mentioned, the way that many of these brokerages compete is, "I will charge a little bit less fees than the brokerage across the street." So there's a little bit more competitive intensity there in that market. Both of these companies are going to be subject to the macro economy. In the case of RE/MAX, it's what's going on in the real estate transactions in the market. In the case of BWX Technology, it's really, what is the governmental political will behind defense spending or behind nuclear power deployments. Both of them have questions about how much of that demand is going to materialize in the future. But for me, I will take the company that is a monopolist that has had upturns in its industry over the past couple of years behind the company in a much more competitive industry that is facing more headwinds.

Rick Mulvey: Nick Sciple, thank you. Jim Gillies, thank you. Now you get to decide who made the better case and who's moving on to the finals of stock market madness. We will have a poll up @MotleyFoolMoney on Twitter. Make sure you vote, and that way, you'll have a say. Thank you both and I'll see one of you next week.

Jim Gillies: Thank you.

Nick Sciple: Getting so much, fool on.

Chris Hill: As always, people on the program may have interests 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.