The Federal Reserve announced a quarter-point interest rate increase at its first meeting of the year, and the central bank guided for six more rate hikes this year. While the recent rate hike was below the half-point increase that some investors had feared, more raises are in the cards, and rising interest rates have historically created a less favorable backdrop for growth-focused stocks and the market at large.
With rate hikes creating potential sources of volatility, now could be a great time to add sturdy, value-focused companies to your portfolio — and where better to start than stocks backed by value-investing legend Warren Buffett and his company Berkshire Hathaway? Here’s why a panel of Motley Fool contributors identified Verizon Communications (VZ), Bank of America (BAC), and United Parcel Service (UPS) as top stocks in Berkshire’s portfolio that are poised to thrive despite rate hikes.
Buy this telecom leader at a better price than Buffett
Buffett and Berkshire made a massive purchase of Verizon stock in the fourth quarter of 2020, and the telecom giant now sits as the investment conglomerate’s seventh-largest overall stock holding. The stock has actually lost ground since Berkshire initiated its position, and that means investors have an opportunity to buy the stock at prices even lower than Buffett got.
Verizon also looks cheaply valued at current prices. The company’s shares trade at less than 9.5 times this year’s expected earnings and boast a current dividend yield of 5%. Even better, the company has raised its payout annually for 15 years straight, and it’s in good position to continue increasing the amount of cash it returns to shareholders.
The telecommunications industry tends to be incredibly capital-intensive, so players in the space tend to carry a lot of debt on their books. However, most of Verizon’s debt has been secured at fixed rates and will be unaffected by subsequent interest hikes. What’s more, Verizon’s sturdy business and stellar free-cash-flow generation have allowed the company to secure loans at very low rates, and it’s likely that will continue to be the case.
While interest-rate hikes can be expected to filter down and lead to higher borrowing expenses, if and when the company pursues new loans to continue building out its infrastructure and purchasing spectrum band for its wireless network, Verizon should have little trouble navigating these shifts. The company’s stock looks cheap trading at less than 9.5 times this year’s expected earnings, it currently sports a dividend yield of around 5%, and the rollout of the telecom’s 5G service could significantly accelerate sales and earnings growth.
Lending’s about to get a whole lot more profitable
Rampant inflation is never good for the economy, and interest-rate increases meant to curb it typically work against it as well. There is one industry that can directly benefit from rising rates, though: banking. And I suspect Berkshire Hathaway’s $44 billion stake in Bank of America will be one of the top beneficiaries of the looming rate hikes.
Simply put, profit margins on lending are greater when interest rates are higher than when they’re lower. That’s because the difference between a bank’s own cost to borrow the money it’s lending out and the interest rates it charges borrowers widens as rates move higher. For perspective, banks’ profit margins in a low-rate environment like we’re in now are closer to 3%, but inch toward 4% (or more) when rates are higher. We’re somewhere between those two figures now.
That may not seem like a significant difference in absolute terms, but think about it like this: The larger of the two figures is 33% higher than the smaller one, meaning a factor that accounts for a huge chunk of banks’ bottom lines could be on the verge of major growth.
The trick is pacing. The Federal Reserve will want to ramp up rates fast enough to keep inflation in check, but not so fast that the U.S. and world economy are shocked into a recession. The Fed’s Federal Open Market Committee, however, seems to fully understand both of these nuances. Either way, Bank of America looks like a worthwhile buy for the long term. And its dividend yield (currently 2%) and payout growth (currently outpacing inflation) should work to the benefit of long-term investors.
UPS is an ideal dividend stock
FedEx (FDX) stock fell 4% on Friday after missing on earnings and beating on revenue when it announced its Q3 fiscal 2022 results after market close on Thursday. Similarly, UPS stock fell on Friday despite an up day in the market.
It’s no secret that UPS is affected by some of the same challenges that FedEx is facing. But both companies are succeeding in passing along higher inflation-related costs to customers. FedEx and UPS raised prices at the beginning of the year. As per FedEx’s results, customers seem willing to accept these higher prices so far.
On Thursday’s earnings call, FedEx said that it was implementing fuel surcharges effective April 4 for FedEx Express, Ground, and Freight. I would expect UPS to announce similar charges in the weeks to come, or when it reports earnings in about six weeks.
FedEx did, however, note that higher labor costs and COVID-19-related headwinds dampened its operating margin for the quarter, which came in at an adjusted 6.2%. Despite FedEx’s emphasis on margin expansion, UPS consistently delivers operating margins far superior to FedEx’s.
UPS is an efficient business that generates tons of free cash flow well in excess of a dividend. This is the exact kind of trait that Buffett tends to look for in a long-term holding. UPS recently raised its dividend by 49%, giving it a current dividend yield of 3% compared to FedEx’s 1.4%. UPS is a more expensive stock than FedEx when it comes to traditional valuation metrics like price-to-earnings (P/E) ratio. But UPS has better management, has a better track record for hitting and exceeding its goals, has been more successful tapping into e-commerce than FedEx, and is a better-run business than FedEx. And for those reasons, UPS is a great package-delivery dividend stock to own for decades to come.
Originally published on Fool.com
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
Bank of America is an advertising partner of The Ascent, a Motley Fool company. Daniel Foelber has no position in any of the stocks mentioned. James Brumley has no position in any of the stocks mentioned. Keith Noonan has no position in any of the stocks mentioned.
The Motley Fool owns and recommends Berkshire Hathaway (B shares) and FedEx. The Motley Fool recommends Verizon Communications and recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.