Three stocks to profit as rates rise

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Henry Dixon, fund manager, Matterley Undervalued Assets Fund.

The recent rise in bond yields is understandably giving investors cause for concern, given the experience of 1994 (when yields rose rapidly in reaction to the Federal Reserve raising interest rates, and bond prices fell, panicking investors). However, history does also show us that equities can deliver attractive returns in an environment of rising bond yields just as long as the starting point in yield is a low one.

For example, from the mid-1950s, UK gilt yields started to rise from 4%, but equities still made progress. Asset allocation played a key part in this and given the significant weighting back then of pension funds to fixed income, the parallels with today are there to see.

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While rising bond yields do narrow down our range of opportunities, it is important to remember that certain sectors can thrive in an environment of rising rates. The resources sector, for example, has found favour in the past, as rising bond yields in theory go hand in hand with a pick up in growth and inflation. This sector has had a torrid time of late (due in part to fears over China's economic growth) and analysis of fund positioning by HSBC shows that the mining and oil sectors are reaching close to a record underweight in investors' portfolios.

However, some company management teams have recently started to reappraise their capital-allocation decisions and adopt a more shareholder-friendly approach. The sector's woes mean there are certain companies that look modestly valued on a number of metrics.

Rio Tinto (LSE: RIO), for example, has now repeatedly guided down its forecast for capital expenditure and outlined its commitment to shareholders in the form of an attractive dividend policy. Today the shares are trading on slightly less than ten times earnings. Should current metal prices hold, then there will be upward pressure on analysts' profit estimates. The starting dividend yield of 4% is well covered and looks set to grow.

Within the oil and gas sector there have also been similarly disappointing share-price performances, as ambitious merger and acquisition deals and exploration attempts have yielded poor results. However, in similar fashion to the mining sector, certain companies are becoming more shareholder friendly in their approach and once again some are now offering attractive entry points.

Soco International (LSE: SIA) is now largely focused on production and trades on nine times earnings with approximately 15% of its market cap in cash. Recent results outlined a special dividend equating to 10% of the market cap and an ongoing commitment to distribute 50% of free cash flow.

Other opportunities presented to us by rising bond yields are those companies with pension deficits. It also should not be forgotten that cash becomes a higher-earning asset. Within the small-cap arena RM (LSE: RM), the education services provider, has both these attributes. The shares trade on around eight times earnings with close to two-thirds of the market cap in cash. While the pension deficit of £20m may put some people off, the recent rise in bond yields will largely negate this, leaving a significant value opportunity.