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Investing is easy. Anyone can do it. All you need is capital and an idea. The hard part is investing in an idea that generates a positive, inflation-adjusted return on that capital in the time you need it to generate a positive return.

Fortunately, the stock market has been a great wealth generating machine for investors with a longer-term time horizon. The historic annualized average return for the S&P 500 is roughly 10% since 1957, but closer to 7% after adjusting for inflation.

That's pretty good either way and it is the basis for pundits preaching the virtue of buy-and-hold investing.

In 2021, it seemed easy to generate great returns buying individual stocks -- or an index fund for that matter. The times, though, they are a changing. They're changing because interest rates are changing. They are no longer as low as they once were, and they are expected to move higher as the Federal Reserve tries to tackle the persistent inflation pressures with a higher policy rate.

That doesn't mean you can't generate a positive, inflation adjusted return on your capital. It just means you must be more discriminating in a rising interest rate environment about the stocks, industries, and sectors in which you invest.

Change Is Coming

Rising interest rates don't necessarily have to be thought of exclusively as a bad thing. Interest rates typically rise for good economic reasons. A stronger economy leads to stronger earnings growth, and the stock market is driven by earnings trends.

Still, rising interest rates inevitably force changes in financing conditions that eventually lead to slower economic activity and slower earnings growth. They also impact stock valuation models, as higher interest rates lower the present value of future cash flows.

The latter understanding has been a driving force for the multiple compression seen in the early part of 2022. Many stocks have seen their earnings multiples (and sales multiples for profitless companies) compress because investors are not willing to pay as much for every dollar of earnings in a rising interest rate environment as they were when interest rates were declining and sticking at lower levels.

They just don't expect companies to be as profitable, or to keep generating the same type of sales growth, that would warrant premium valuations.

Even so, at 19.7x forward 12-month earnings, the S&P 500 is still trading at a 6% premium to its 5-yr historical average and an 18% premium to its 10-yr historical average, according to FactSet. That's before the Federal Reserve has raised rates even once from the zero bound and before the 10-yr note yield has touched 2.0%.

The stock market, though, is forward looking and recognizes that higher rates are on the way, so it is starting to discount that reality now.

The stock market's behavior has been extra volatile to start the year and losses in many individual stocks have been outsized, not only because of the upward path in interest rates but because of the rapid change in interest rates.

When the year began, the 2-yr note yield, which is more sensitive to changes in the fed funds rate, stood at 0.72%. It is at 1.31% today. The 10-yr note yield, which ended 2021 at 1.51%, is at 1.93%. The fed funds futures market is pricing in the probability of at least five rate hikes by the Fed in 2022, whereas it was considering three rate hikes this year a close call at the end of 2021.

The change has been a function of the ongoing inflation pressures and signaling from the Fed itself. It has also been a function of signaling from other central banks, which are also aiming to tamp down inflation pressures of their own. To be sure, the inflation seen in the U.S. is not just a U.S. problem.

A Counter Argument

We know, then, in the context of this rising interest rate environment that inflation is a problem. From an investment standpoint, that creates investment opportunity in companies that can provide an inflation hedge.

That would include commodity-related stocks that can be found in the energy and basic materials sectors.

It also includes companies that can retain pricing power and where demand for a product or service is inelastic, meaning a change in price isn't going to change the demand for a product or service by a large amount.

That would include health care and consumer staples companies. Those companies are known as counter-cyclical companies. That is, they tend to do well even when the economy is suffering since the demand for their products or services is fairly constant.

The utilities sector is another counter-cyclical sector, although rising interest rates can still spell problems for these stocks since many utilities companies carry high levels of debt given the investment-intensive nature of their business and pay attractive dividends that might be seen as less attractive versus the income that can be provided by a risk-free Treasury.

In general, though, a rising interest rate environment that triggers an economic slowdown often produces better relative returns for counter-cyclical sectors.

The financial sector is another area that tends to do well when rates start to rise. Banks generally find some investment favor on an assumption that a steepening yield curve, which is typically associated with a strong economy, will drive increased profitability on the back of increased loan demand, higher investment income, and an expansion of net interest margins. Insurers also tend to benefit as they are able to generate more investment income when Treasury yields are higher.

Finding Value in Value

When interest rates go up, you generally want to avoid stocks trading with high valuations relative to the market and their peer group. They will get hit the hardest in the event of an earnings disappointment or, in the case of companies not making money, a slowdown in sales growth.

Stocks accorded premium valuations are growth stocks. Many also carry a moniker of being long-duration issues, meaning a significant amount of their cash flows won't be seen until the distant future. Consequently, rising interest rates lower the present value of those distant cash flows.

In the same vein, longer-duration bonds are also prone to underperformance since they are more sensitive to changes in interest rates.

Stocks that tend to do better when interest rates start to rise are value stocks. Value is a relative term and there are different analytical approaches for determining what is a value stock. A standard definition is a stock trading below its intrinsic value. Generally, stocks trading at a discount to the market multiple are considered to be value stocks.

Presumably, they carry more upside potential in an improving economy that is accompanied by rising interest rates since they have improved earnings surprise potential that is not reflected in their discounted valuation. Many value stocks are value stocks because of a prior growth disappointment. Some also get left behind because the value factor is out of favor in a market that had previously favored growth stocks.

There is relative value, then, versus the market and relative value versus industry peers. If one is looking to buy a value stock, it is important to distinguish why the stock is trading at a discount to its peer group. That would help avoid falling into a "value trap," as opposed to investing in a value stock that truly outperforms in a rising interest rate environment.

The relative valuation analysis can be looked at through different ratios, such as price-to-book ratios, P/E ratios, and price-to-earnings growth ratios.

Another generally successful approach in a changing interest rate environment that features rising interest rates is to avoid speculative story stocks and to embrace stocks of established companies that are profitable, free cash flow positive, pay a dividend, and have good balance sheets. That would be blue-chip companies.

In brief, one should be looking to buy quality companies at a reasonable price as opposed to buying unprofitable companies at any price. The latter can work for a time when interest rates are at rock-bottom levels and aren't thought to be going up soon, but when that perspective changes, the pool of marginal buyers typically gets much shallower and subsequent declines in the event of a disappointment get much deeper.

What It All Means

When interest rates change, investment approaches will also change. Investing in a rising interest rate environment requires more humility and a lot less bravado because inflation-beating returns will be harder to come by. In turn, market volatility will be higher.

Value stocks tend to do better than growth stocks as interest rates start to rise. Eventually, interest rates reach a tipping point for the economy, and when it becomes apparent that higher rates are leading to much lower levels of growth, then growth stocks will start to exhibit some relative strength again.

Of course, one can always stick with the simple approach of owning an S&P 500 index fund. That can be painful to endure at times, but if time is on your side and you have the latitude to hold through the more challenging times, the historical track record speaks for itself as a good investment idea that will provide you a positive, inflation adjusted return on your capital.