Take the Federal Reserve at its word. Whether it cuts interest rates again on June 25 or leaves the fed funds rate at its current 1.25%, Alan Greenspan and company have promised low interest rates for as long as it takes.

With Europe on the verge of recession, Japan still unable to end its embrace of deflation, U.S. unemployment at 6.1% and capacity utilization at manufacturing companies hitting a new low of 72.5% for this cycle in April, "as long as it takes" could take quite a while.

So investors ought to invest as if low interest rates will be around for a good while.

If you're a homeowner, it's clear what that means: Refinance and refinance again until you've wrung every last point out of the interest rate you pay on your mortgage, and fix that rate in concrete for the life of your mortgage.

But what does it mean to be a low-interest-rate investor? I think it's time to go beyond the conventional generality that low interest rates are good for the stock market and come up with some specific pros and cons for an environment that we'll all have to live with "as long as it takes."

What to Look For

Here's my first cut at what to look for in this low-interest-rate environment. Seek companies:

  1. that face as little pricing pressure as possible from excess capacity at competitors;
  2. with strong balance sheets that can raise capital cheaply;
  3. that have lots of opportunities to put that cheap capital to work;
  4. whose new projects earn returns as high as possible over the cost of the new capital that funds them; and
  5. whose new projects show returns that are not significantly lower than those for the company's existing businesses.

Let's start by getting rid of that current bit of conventional wisdom: Low interest rates are not good for all stocks, as many investors seem to believe right now.

Low interest rates do make stock valuations look cheaper, and that does tend to lift stock prices. But there's no such thing as a free lunch in the financial markets, so -- what do you know? -- low interest rates also work to depress earnings at many companies. Especially in an economy like this one.

Self-Defeating Policy

In one of his investment letters recently, Richard Bernstein, Merrill Lynch's chief market strategist, pointed out that the Federal Reserve's low-interest-rate policy was actually keeping alive the very excess capacity that's at the root of current deflationary pricing pressures. By making money cheap and plentiful, Bernstein argued, the Fed was making it possible for cash-strapped marginal competitors to stay in the game rather than go out of business.

Of course, this refinancing patch job doesn't really fix anything in the long run. It simply prolongs the death throes of some very inefficient and badly run companies. Refinancing debt at a lower cost doesn't improve the product, strip costs out of manufacturing or bring new customers in the door.

But it does keep the pressure on prices. In industries with excess capacity, any competitor that doesn't go out of business, thanks to refinancing debt at a lower interest rate, is still around to pump out product and compete for customers -- and put more downward pressure on prices.

The Airline Example

In the airline industry, you can see it now in the pricing pressure being applied by two big airlines, one in bankruptcy and the other skating on the edge. The United Airlines unit of UAL and the American Airlines unit of AMR ( AMR) slashed fares to the bone and then slashed them some more.

Fly three round-trips on United Airlines and you get a free ticket. American Airlines recently offered a round-trip ticket between Las Vegas and Boston for $249. That's roughly $60 less than the cheapest round-trip fare I found on JetBlue ( JBLU), an airline with much lower costs than American, even after its recent worker concessions.

So that's the first rule for low-interest-rate investing: Avoid industries with huge excess capacity where cheap money, thanks to the Federal Reserve, is keeping marginal competitors alive and price competition fierce.

If that's what an investor should avoid, what should an investor look for?

In a low-interest-rate environment, it's all about spread -- the difference between what a company pays for its capital and what it earns from deploying that capital in its business. As I've just explained, this economy will remain a tough place to make a profit, so it helps if a company starts off with as low a cost of capital as possible. Risky companies may be able to raise money, thanks to low rates, but they aren't raising money at 1.25%.

For instance, Texas Industries ( TXI), the cement and steel maker, recently sold bonds priced to yield 10.75%. Contrast that to the AAA-rated Berkshire Hathaway ( BRK.B), where the cost of capital in 2002 came to just about 1%. In the first quarter of 2003, the company's cost of capital fell to zero.

Cheap Capital

Now which company, Texas Industries or Berkshire Hathaway, is going to have an easier job making a profit on its cash? Rule No. 2 says that in this environment you should look for companies closer to the Berkshire Hathaway end of the cost-of-capital scale.

But Rule No. 3 reminds investors that cheap capital isn't an end in itself. The goal is to invest it.

Not every company has equal access to new investment opportunities. Some companies are in mature and contracting industries. Think what it means about the software industry if we take Oracle ( ORCL) CEO Larry Ellison at his word and believe that the best use he can find for $5.1 billion of his company's cash is to buy competitor PeopleSoft ( PSFT) for its customer list and then shut down that company's product line.

But remember Rule No. 4, which says a company is looking for not just any investment opportunity, but one that generates a return on capital that's higher than the company's cost of capital.

In some industries, that kind of business opportunity seems rare to nonexistent right now. A seller of long-distance residential phone service such as AT&T ( T) faces such relentless pricing pressure in its own industry that it can't hope for stellar returns on invested capital from investing in the business it knows best. The average five-year return on capital at AT&T is just 1.9%.

On the other hand, a company like video game retailer GameStop ( GME), which is still expanding by building new stores and still grabbing market share in its industry, shows a recent return on capital of 9.5%. The company simply has more opportunities than AT&T for putting its capital to work at a profit.

But making a profit on newly invested capital isn't a sole hurdle. Hence Rule No. 5: Look for companies that are making a rate of return on newly invested capital that's at least roughly equal to the returns delivered by past investments.

The Microsoft Problem

Call this the Microsoft ( MSFT) problem. When a company has a history of making a return of 20% on invested capital, as Microsoft does, the most recent return on capital of 16.5% seems low.

Do you know of many businesses where a CEO can hope to earn 16.5% on capital? That's the worry facing an investor looking at the long-term earnings growth at companies such as these. If new opportunities for putting cash to work will earn lower returns than the company's existing business, investors have to think twice about paying historically high price-to-earnings ratios for these stocks.

Ideally, what you want in this environment is a company with a record of finding solid new business opportunities that offer returns well above the company's cost of capital. But for future stock-price appreciation, that record shouldn't set the bar so high that new investments are likely to fall far short of past returns.

One company that comes to mind is Berkshire Hathaway. The company's five-year average annual return on invested capital is 4%, but in the most recent annual period, return on capital climbed to 6%. That's a low historical benchmark to beat, and recent returns are certainly moving in the right direction.

So with this column, I'm adding Berkshire Hathaway as my first low-interest-rate play in Jubak's Picks. (But I'm buying the class B shares; the class A shares sell for $72,400 each. The B shares go for $2,415.)

At the time of publication, Jim Jubak owned or controlled shares in Berkshire Hathaway, GameStop and Microsoft. He does not own short positions in any stock mentioned in this column.

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