Market Contractions: Ouch!

Inflation. To investors, it's a four-letter word (unless, of course, you're one of those twisted gold investors). Yet inflation fears are front and center in Mr. Market's mind lately. For those who have wanted to see it, evidence of higher inflation is everywhere in the market. Commodity and resource prices (oil, gold, etc.) are in a multiyear bull market -- a strong inflation signal -- and the U.S. dollar has fallen dramatically over the past four years. Combine these indicators with rising producer and consumer prices, and the warning signs start flashing.

Historically, rising inflation has always been accompanied by rising interest rates. Responding to questions during a January speech to German bankers, Alan Greenspan commented that, "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged his position by now, obviously, is desirous of losing money."

Strong words from the Maestro (of Easy Money) -- words that growth investors buying stocks with high P/E multiples should consider a warning. While still historically low, long-term bond yields are finally starting to creep up. Since early February, the yield on the benchmark 10-year Treasury bond has moved from around 4.0% to 4.5% (although it's come back somewhat in recent days).

Most investors have heard that rising interest rates are bad for stock prices. I'm going to explain why they're bad. Investors understand that rising interest rates increase borrowing costs, and that, in turn, increases interest expense, crimps capital expenditures, and hurts earnings. Might it be fair then to conclude that companies with no debt shouldn't be affected by rising interest rates?

Sort of.

It's possible that rising interest rates will have no effect on a debtless company's operating costs, but it will have an effect on the stock price, as higher interest rates ultimately devalue a company's future cash flows. Equity investors want to be compensated for the lower value of those cash flows, and therefore increase the return required on their investments. Since, as students of Foolish investing, we understand that the intrinsic value of a company's stock is the discounted present value of future cash flows, we know higher discount rates lead to a lower intrinsic value, in a phenomenon known as multiple contraction.

A discount on future earnings
Multiple contraction is a term used to describe the point when, all other things being equal, a stock's price/earnings ratio drops as a result of a fall in the stock price. It can be an industry-wide, or in some cases a market-wide, phenomenon, predicated on either a lower growth forecast, or, as in our scenario, a rise in interest (discount) rates.

Let's look at an example using America's most admired company, Dell (NASDAQ:DELL), which, at $35, is trading at 30 times trailing fiscal 2005 earnings.

Analysts expect earnings to grow 34% this year, and Value Line predicts "cash flow" (which they essentially define at net income plus depreciation and amortization) of $1.85 per share for FY05. That may appear to justify the premium P/E ratio. But as we'll see, when interest rates rise, that premium will shrink.

Subtracting Value Line's capital expenditures estimates from their "cash flow" prediction gives us free cash flow per share of $1.60 and $1.85 for the next two fiscal years. Assuming 15% growth from 2008 to 2010, and 3% growth ad infinitum, we can calculate Dell's intrinsic value. Now, let's suppose we've determined that a discount rate of five percentage points over the 10-year treasury yield (4.5%) adequately compensates us for Dell's risk. Based on this, our required return, or discount rate, is 9.5%. (You can use different values in the model -- you'll find the results follow the same pattern.)

These assumptions produce free cash flows that look like this:

To calculate a "terminal" value we'll use the old perpetuity formula:

Terminal Value = 2011 FCF/(discount rate - growth rate)

In this case: Terminal Value = $2.90/(.095 - .03) = $44.59

Put it all together and, at a discount rate of 9.5%, the present (intrinsic) value of Dell's future earnings is $36.44, or close to the current price. Let's see what happens if interest rates rise a bit.

Suppose the 10-year treasury rate rises to 5.5%, and our forecast for Dell's future remains the same. If we maintain our assumptions, the new discount rate is 10.5%, and Dell's intrinsic value falls to around $31.34 per share, roughly 13% below the current price, at a lower P/E of 26 times earnings. If the 10-year treasury rises another percentage point to 6.5%, Dell's intrinsic value falls to $27.46, and the P/E shrinks to 23.

That's what we mean by multiple contraction, and it highlights the real danger equity investors face in a rising interest rate environment. In the current climate, investors are willing to pay 30 times earnings for Dell's stock. However, if long rates rise a couple of points, they may only be willing to pay 23 times earnings, driving the stock price down 24%.

Investors are currently faced with the harsh reality that we've entered a period of both rising rates and slowing profit growth -- a double whammy for bullish investors. Last year, the Fed Funds rate doubled from 1% to 2%, with indications that it will continue rising. At the same time, year-over-year earnings growth for the S&P 500 fell from 26% in the first quarter of 2004 to about 15% in the fourth quarter, and a number of large companies are saying that 2005 profit growth will be even lower.

Protecting yourself
By now you might be thinking, "Thanks for the doom and gloom workshop. Now, what I really want to know is how, as a Foolish investor, I can invest defensively in the face of contracting multiples."

Good question. Absent leaving the market altogether, I can think of a couple of risk-reducing moves to make. There's no guarantee you'll totally avoid the effects of multiple contraction, but you'll limit your downside.

The first, and probably best, decision is to buy stocks of quality companies with above-average dividend yields, like Altria (NYSE:MO) or Motley Fool Income Investor pick RPM International (NYSE:RPM). With dividend payers, you get the benefit of cash in hand, and since most of these companies trade at lower relative P/E ratios, they'd hopefully have less room to contract in the market's psyche.

Another alternative for you risk-takers is to invest in precious metal companies like Newmont Mining (NYSE:NEM), or resource companies like ExxonMobil (NYSE:XOM), whose earnings growth in an inflationary environment should offset the negative effects of higher interest rates. Resource companies, particularly oil and gas, have greater pricing power by virtue of being generally positioned near the beginning of the value chain. They can pass on the rising price of raw materials more easily than the companies further down the chain.

Finally -- and this applies in any market, at any time -- buy quality companies on the cheap. Value investing is a smart way to play a contracting market, because in most cases you're buying companies with already low P/E and cash flow multiples. When the market multiple starts collapsing, value stocks, such as Motley Fool Inside Value pick Lloyd's TSB (NYSE:LYG), don't tend to fall as far as growth stocks.

Conclusion
In my opinion, the U.S. economy, while probably not headed for dire circumstances as some predict, does have a number of structural imbalances to correct. Monetary inflation (with its host of negative implications), and the normalization of interest rates will be a big part of this correction. Stocks have taken a beating recently, as Mr. Market has started coming to grips with economic reality, and stopped partying like it's 1999. When he finally feels the full effects of rising interest rates, I wouldn't want to be holding a bagful of "growth" companies.

For related reading, check out Dell's Scary Efficiency.

Fool contributor Chris Mallon is one of those twisted gold investors, and owns shares in Newmont Mining, Altria, and RPM. The calculations in this article are for entertainment purposes only, as he actually has no idea what Dell's future earnings will look like. The Motley Fool is investors writing for investors.