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TORONTO (GlobeinvestorGOLD) — As the manager of a small-cap portfolio with a long investment horizon, I don't spend much time worrying about the negative implications of higher interest rates.
There are several reasons for this intellectual laziness on my part. Perhaps the simplest explanation is that they don't make up a large part of the small cap sector: in total, financial services and interest-sensitive stocks make up about 10 per cent of the Canadian small cap universe and are represented by companies such as Canadian Western Bank, Kingsway Financial and a few small real estate operators such as O&Y Properties and Revenue Properties. In contrast, the big cap S&P/TSX composite index is almost 40 per cent exposed to financial services and interest sensitive stocks. So, if your portfolio looks like the S&P/TSX composite, you should pay attention to Federal Reserve Chairman Alan Greenspan and the interest rate prognosticators. If you own small cap stocks, you have other things to worry about.
One of the paradoxes of small cap investing is that while the stocks you own are individually risky, when you put them together in a diversified portfolio they reduce the risk dramatically. This is because most of the risks of ownership are specific to that company and are largely independent of the big-picture economic environment. Looking back at the small cap companies mentioned in the first paragraph, it should be obvious that Canadian Western Bank's success is driven more by the local economy of Alberta and BC than Federal Reserve decisions on 25 or 50 basis-point rate hikes.
Similarly, Kingsway Financial's stock price is driven by motorcycle and high-risk driver accident rates and O&Y Properties' stock price is driven by their success in finding tenants for the new office tower at Yonge and Queen in Toronto. This does not mean that small cap stocks will go up even if the S&P/TSX composite plunges due to rate fears — they are after all Canadian stocks in the Canadian market — but the small cap investor should devote little attention to macro-economic headlines when the portfolio is mainly sensitive to company-specific issues.
Having said that, are there any stocks, large or small, which would benefit from rising interest rates? The simple answer is that any company with a net cash balance would benefit from higher interest rates because the investment income return on the portfolio will rise more than the interest expense on the debt. While this is true theoretically, the reality is that interest rates are currently so low that a 25 or 50 basis point increase in rates will not have a measurable impact on earnings per share within the time horizon of a typical investor.
Which brings me to my final point: unless you fall into the camp of investors who expect interest rates to return to double digits and gold to hit $1,000 an ounce, then rate hikes of 50 to 100 basis points, which are part of most forecasts, will not exactly bring the economy to its knees. In fact, modest rate increases as a result of robust economic growth would probably be viewed as a net positive for the stock market. If you were to ask corporate managers whether they would accept a 1-per-cent increase in interest rates as a package deal along with 3- to 4-per-cent GDP growth this year, I suspect that most managers would take the deal.
So, if you are a small cap investor, maintain your focus on the details and company specific issues. Let Alan Greenspan worry about the forest; you should focus on the trees.
Robert Tattersall is President and partner at Howson Tattersall and a recognized expert on small cap stocks in Canada.