Traditional “Value” Stocks are arguably some of the most unsafe picks in a rising interest rate environment

Title. I’ve seen too many people in here flood into traditionally “safe” companies as they have weathered the recent volatility. I’m here to tell you that the risk/reward on these companies is terrible, and even under optimistic assumptions you are guaranteeing subpar returns. I’m specifically talking about the value stocks that trade close to a 25-30 PE, like $KO, $PG, etc.

Hypothetically, if there was a company that was absolutely, 100% guaranteed to have the exact same net income every year for the next decade, and every investor knew this, this investment would trade extremely close to long term yields, or the risk free rate. Obviously a company like this doesn’t exist, but there are several companies that have consistent net income, even during bad times, although almost no revenue growth.

A great example is $KO. Coke trades currently at a 27 PE, and even with inflation their earnings have been flat over the past decade. It is very likely you will see flat earnings over the next decade as well. At a 27 PE and almost flat net income, you should expect a little less than a 4% return on your money, as the company can buy back a little under 4% of its shares or issue close to a 4% dividend. This makes sense, as the risk free rate now is around 3%, meaning your making 1% more, for a little more risk.

The issue is when these yields rise. With inflation running hot, it is likely that these yields will only get higher for the foreseeable future. If yields start paying 4%, it becomes ridiculous to take any risk of lower net income with $KO, meaning massive compression in its P/E. Where this settles is impossible to tell though. At a 20 P/E, almost a 30% drop from here, you would only get a 5% return while taking risk, is this worth it when the risk free rate is 4%? This means a 100 BPS move in yields could easily drop $KO and other traditional value plays 30-40%, and this assumes yields top out at 4%. The risk is obviously still there with any growth companies, but I’d argue it’s less for them after the already big drops.