The Federal Reserve seems to be following a disciplined but slow policy of increasing interest rates. According to officials quoted in the financial media that seem to be familiar with the Fed’s policy making process, the Fed could raise the Fed Funds rate to more than 1.5% by the end of the year, well above the record low near 0% but well below what investors would like to earn on short term deposits.
The Fed Funds rate is the benchmark short term rate the Fed sets. This is technically the interest rate that banks and credit unions charge other depository institutions for overnight, uncollateralized loans.
The chart below uses data from the Federal Reserve to show how unusual the past few years have been.
In the past, low rates were intended to be a temporary solution to the problem of slow economic growth. Economists believe rates should move up and down with economic activity. As the economy slows, before and during a recession for example, the Fed has generally cut interest rates. This made it less expensive for companies to borrow money that could be used to expand their business and create jobs, which should help bring the recession to an end. When the economy recovers, the Fed raises rates to prevent the economy from overheating and falling into an inflationary spiral.
For almost a hundred years, the Fed followed this strategy of fine tuning economic growth with changes to the interest rate. The strategy helped the economy grow in the long run. This policy also benefited investors who enjoyed solid rates of returns on short term savings that generated interest rates tied to the Fed’s short term rates.
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But, as the chart shows, something changed in recent years. For the first time ever, the Fed pushed short term rates to zero in an effort to boost economic growth. After the last recession ended, the Fed seemed nervous that a rate increase would spark a new recession. As a result, they kept rates near their historic lows and they remain near record lows more than eight years after the recession officially ended. In this current environment, investors can no longer count on even 1% yields on their savings and bonds pay interest rates that fail to meet the needs of many investors.
This situation has been going on so long that it seems unlikely to change. The Fed may be in a hurry to raise rates just so they can cut them during the next recession. That seems like it is one of their primary objectives at this point. The Fed has always battled recessions with interest rate cuts and the last recession ended more than eight years ago. As the next recession nears, the Fed needs to create room for cuts.
As investors, this creates a new environment for us to consider.
Income from fixed income investments is likely to remain low for many years in the future. That means stocks are likely to become increasingly attractive to investors who need income. They will be forced to accept the risk of the stock market trading to generate yields greater than 1% that is available in short-term deposits. In many cases, they may find the risk of stocks more tolerable than the risk of bonds which could lose value if interest rates rise unexpectedly.
To help investors find income, we searched our database for companies that pay dividends and are growing earnings. The companies will be able to use increased earnings to increase their dividends if they choose to and that would result in more income for shareholders. Specifically, we searched for stocks providing annual dividend yields of at least 3% and therefore offering more income than Treasury bonds. We also required the companies to have high earnings growth, an average of at least 10% a year according to analysts’ estimates. As we often do, we focused on low priced stocks, the kind of stocks capable of delivering rapid growth. This list of four stocks are all trading at less than $15 a share.
Medical Properties Trust, Inc. (NYSE: MPW) is a real estate investment trust (REIT) that acquires, develops, and invests in healthcare facilities; and leases healthcare facilities to healthcare operating companies and healthcare providers. The company also provides mortgage loans to healthcare operators, as well as working capital and other term loans to its tenants and borrowers.
MPW offers a yield of about 7.3%. Analysts expect the company to grow earnings at more than 11% a year which would support an increased dividend. As a REIT, it is important to remember that MPW is required by tax law to pay out substantially all of its earnings as dividends.
Big 5 Sporting Goods Corporation (Nasdaq: BGFV) is a sporting goods retailer in the western United States. The company provides full-line products in a traditional sporting goods store format. The product mix includes athletic shoes, apparel and accessories, as well as a broad selection of outdoor and athletic equipment for team sports, fitness, camping, hunting, fishing, tennis, golf, winter and summer recreation and roller sports.
The retail sector is struggling and that is hurting even well managed companies like BGFV. At the current price, the stock offers investors a dividend yield of about 4.4%. This is well above the average yield of the stock. Over the past five years, BGFV has traded with an average dividend yield of 3%. To return to that level, the stock would need to appreciate about 43%. Analysts expect earnings growth to average 15% a year. As a survivor in a shrinking sector, earnings growth seems likely to unfold and the stock could gain more than 40% given its current valuation.
Barnes & Noble, Inc. (NYSE: BKS) sells trade books, including hardcover and paperback consumer titles; mass market paperbacks, such as mystery, romance, science fiction, and other fiction; and new, used, and digital textbooks, as well as children’s books, eBooks and other digital content, NOOK and related accessories, bargain books, magazines, gifts, café products and services, educational toys and games, and music and movies. Barnes & Noble also offers textbook rental services.
BKS offers a dividend yield of almost 9% at the current payout of $0.15 a quarter. BKS is generating a large amount of cash flow of operations, more than 4 times as much as the dividend payments in the past year. This cash flow could continue to fund a generous dividend, especially if earnings growth averages 10% a year as analysts expect.
Meridian Bioscience, Inc. (Nasdaq: VIVO) manufactures, markets and distributes a broad range of innovative diagnostic test kits, purified reagents and biopharmaceutical enabling technologies that help deliver answers to patients. Its products assist in the early diagnosis and treatment of common medical conditions, such as C. difficile, H. pylori, foodborne diseases, and respiratory infections. The company also develops and manufactures a variety of biological and non-biological materials used in proficiency testing programs.
VIVO’s yield of 3.3%. Earnings growth is expected to average 17% a year. Despite the rapid earnings growth, the stock trades at a discount to its industry. The price to earnings (P/E) ratio is about two-thirds the medical equipment and supplies industry average.
These four stocks offer a combination of income and growth. This combination could be the best way for investors to protect themselves against the risks of inflation and the low interest rates the Federal Reserve seems to be intent on maintaining for years to come.