These Companies Might Benefit from the Fed’s Tightening

Real estate agents tend to be among the most optimistic people in the world. Asked if now’s a good time to buy the answer is invariably something like “of course it’s a good time to buy because prices will be higher soon and you don’t want to miss out on those gains.” Low unemployment, to real estate agents, means there are more potential buyers. High unemployment indicates demand is building and buyers will flood the market once the economy turns higher. In a discussion with a real estate agent, expect any scenario to lead to the conclusion that now is the time to buy.

Sometimes, their arguments are unusually strong. Right now, with the Federal Reserve expected to raise rates soon, real estate agents are bracing for buyers who kept waiting for rates to fall. When mortgage rates start moving up, they expect panicked buyers to rush into the market hoping to avoid even higher rates. This argument makes sense and it also makes sense for companies that have issued large amounts of short-term debt – Fed action could prompt them to strengthen their balance sheets by refinancing the short-term debt with long-term debt that locks in low rates. That type of refinancing might make the stocks more attractive to value investors.

To find companies that could benefit from higher interest rates, we identified companies with large amounts of short-term debt. Specifically, we found companies whose short-term debt was greater than the amount of their long-term debt. These companies could benefit from refinancing their debt to lock in low rates and might choose to offer long-term bonds when the Fed acts. This action could boost their stock price by eliminating the uncertainty associated with rolling over short-term debt. Management could then focus on operations rather than continuous refinancing.

To find companies likely to deliver gains, we limited our search to companies whose earnings estimates were increased within the past three months. Finally, we looked at the lowest priced companies since relatively small changes in low-priced companies can lead to large changes in the stock price. We found four companies priced below $20 a share that met all of our requirements.

KCG Holdings, Inc. (NYSE: KCG) is a pure-play, execution-only securities firm dedicated exclusively to trading. It is a market maker, a firm that is willing to hold an inventory of stocks to facilitate trading. For example, if you want to buy or sell 100 shares of a thinly traded stock, KCG might take the other side of your trade until they found someone else willing to trade in that stock. They have built a platform capable of executing trades in less than a second, allowing the company to participate in the markets with high frequency trading firms.

Traders require liquidity and KCG is providing liquidity with its systems. There is actually a large market for liquidity and traders pay billions of dollars to access markets. In the U.S., traders at all levels paid commissions totaling $10.3 billion last year according to the research firm Greenwich Associates. In Europe, commissions totaled an estimated $4.6 billion and there were billions more spent in Asia. KCG is seeking a larger and larger piece of this business with its automated execution system that is available to institutional traders. The company serves as a market maker and trading partner for more than 19,000 U.S. equities allowing firms to find liquidity in almost any stock whenever it’s needed. Wide access to securities has resulted in KCG gaining an increasing share of the market. The chart below shows the percentage of exchange-traded volume the firm has handled every month since January 2014. Many trades are completed in dark pools and other venues that are off of exchanges and are not included in this data.

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Earnings have varied widely over the years as KCG spent heavily on infrastructure to create its electronic marketplace. Analysts believe that the company should now be able to grow earnings at a steady pace of about 10% a year. With steady growth, the stock should begin trading in line with other companies in the investment services industry. On average, stocks in this industry trade with a price-to-book (P/B) ratio of 2.0. This offers a price target of $33 for KCG, more than double the current price.

Action to take: KGC is a buy above $14.15. Consider a stop at $12.64. The short-term (3 to 6-month) price target is $19.12. The long-term (12 to 18-month) price target is $33, a level the stock traded at in 2012.

MFA Financial, Inc. (NYSE: MFA) is a real estate investment trust (REIT) investing in residential mortgage assets. As a REIT, MFA is required to distribute substantially all of its adjusted cash flow, roughly equal to earnings, to its investors and has historically provided a high yield of more than 10%. The stock price is recovering from a collapse driven partly by concerns about how higher interest rates would impact financial companies.

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Investors now seem resigned to higher rates and many financials are recovering. MFA’s steady dividend should allow the stock to trade close to the industry average P/B ratio of 1.6, providing a price target about 70% above the current price.

Action to take: MFA is a buy at $7.25 or above. Consider placing a stop below the recent lows at $5.98. The short-term target based on the chart pattern is $9.93. The long-term target based on fundamentals is $12.33.

NeoPhotonics Corporation (NYSE: NPTN) develops optoelectronic products that transmit, receive and switch digital optical signals for communications networks. Its products are used in ultra-high speed digital optical communications, high speed switching and provisioning, and access connections for wireless and fiber-to-the-home communications networks. After years of losses due to high development costs, NPTN is expected to turn profitable this year. However, the pace of earnings growth recently disappointed investors. The stock’s selloff last month seems to be overdone and created a buying opportunity.

At the end of April, management said it expects earnings per share (EPS) to be between $0.08 and $0.15 on revenue of $97 million to $102 million for the current quarter. Analysts had been expecting EPS of $0.19 and revenue of $101.7 million. Based on the new guidance, analysts lowered their expectations for the quarter but maintained their full year EPS estimates of $0.68 for 2016 and $0.91 for next year. At the current price, NPTN is trading at just over 10 times next year’s estimates.

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The stock price is likely to recover and could trade near $12 per share before encountering significant resistance.

Action to take: NPTN is a buy above $9.70. Consider a stop at $8.40 where long-term support should develop. The initial price target is $12 where the gap offers potential resistance.

SLM Corporation (Nasdaq: SLM) originates and services loans it makes to students and their families to finance the cost of their education. SLM makes Private Education Loans that supplement government-backed loans for students to cover all the costs of attending college. The company also operates Upromise, a consumer savings network that provides financial rewards on everyday purchases to help families save for college.

The stock has been volatile on well-publicized concerns about student loan defaults. SLM’s latest quarterly results indicate these concerns might be overblown. The company reported just 2.1% of its outstanding loans were delinquent with payments more than 30 days past due. This was down from 2.1% in the previous quarter, a downtrend that management emphasized was positive. Digging deeper we find the latest number is above the 1.7% rate reported a year ago. The conclusion is the same that the trend is at least stable and delinquencies are a problem that SLM should be able to manage. It’s important to remember the company eventually collects on almost of its loans since student loan debt is not dischargeable in bankruptcy. If a loan remains unpaid, a borrower’s Social Security retirement benefits can be garnished.

The realities of the student loan market indicate SLM is most likely a safe investment. The stock is likely to return to its 52-week highs above $10 based on the chart action. Momentum, shown as the stochastics indicator in the chart below, turned bullish as the stock was bottoming at the beginning of the year. The recent bullish crossover occurred while stochastics remained above 50, an indicator of a strong uptrend.

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Action to take: SLM is a buy at $7.25 or higher. The price target is $10.05 where the stock is likely to encounter resistance. This is also the price where the P/E ratio based on next year’s expected earnings will be 15, the average P/E ratio for the industry. Consider an initial stop just below the recent lows at $6.10