As concerns over a full-blown trade war mount, it is unsurprising that the market is a bit skittish. There has yet to be a real turn against the current bull market, let alone anything like a full-blown panic. Yet it is still prudent for investors of all stripes to be on their guard and to position themselves in anticipation of – or at least as a hedge against – a reversal in the market. That is especially true in the present, long-running bull market, which has seen many companies increase leverage in an environment of extremely low interest rates. As rates begin to rise, that leverage may become a problem.

In previous research notes, we have discussed ways in which investors could play the mounting China tensions, as well as pointing out various securities that could do well in the event of a trade war. In this research note, we discuss a similar theme. Specifically, we explore companies with strong balance sheets and solid earnings that are not susceptible to the perils of high leverage in a higher interest rate market.

Easy money leads to overleverage

As corporate borrowing reaches unprecedented levels, the threat of rising rates or general downturn is magnified.

David Kostin, the top equity strategist at Goldman Sachs (NYSE:GS), recently offered a compelling explanation of the benefit of a strong balance sheet:

“Strong balance sheet stocks have historically outperformed weak balance sheet stocks during environments of rising leverage. We expect financial conditions will continue to tighten from record easy levels…We have recommended investors own strong balance sheet stocks given the backdrop of record corporate leverage and Fed tightening.”

Looking for stocks with strong balance sheets has long been a popular strategy of value investors, and for good reason. A solid asset base and stable (and preferably growing) earnings have been the foundation of virtually every value play. As rates tighten, many of the high-flying stocks that have enjoyed the easy borrowing environment of the past decade may well start to feel the squeeze. With equities already at record valuations, there could be considerable pressure on such companies as policy tightens – and especially in the event of a downturn.

Thriving in lean times

Companies with strong balance sheets are not just historical outperformers in times of rising leverage, but are also well placed to grow under such conditions going forward. As Kostin wrote:

"In contrast with history, many of the companies with the strongest balance sheets today are also the companies with the strongest growth. In our base case, a healthy economy will lead the Fed to tighten financial conditions, lifting interest costs. If economic growth slows, however, currently healthy interest coverage ratios will weaken as earnings decline. Both environments should benefit firms with strong balance sheets."

In other words, looking for companies with strong balance sheets may well be the top growers over the next while, regardless of whether the economy continues to hum along or stalls.

It’s the balance sheet, stupid

If the economy is strong, rates will keep rising, which will put pressure on leveraged companies. Companies with low leverage and strong balance sheets will be able to invest in growth while their debt-laden counterparts have to pay more interest.

If the economy loses steam, companies with lots of debt will find their leverage problems get worse thanks to decreased earnings. That is not a problem for those with strong balance sheets.

Regardless of the economy’s trajectory, strong balance sheet stocks should be on value investors’ radars.

Disclosure: I/We own no stocks discussed in this article.

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