Thomas Soviero unseated Ken Heebner as manager of the best-performing diversified U.S. stock fund over the past 10 years. His secret: Companies with poor credit.
Soviero’s $4.2 billion Fidelity Advisor Leveraged Company Stock Fund averaged 15 percent annual returns through March 31, best among 3,617 peers tracked by Morningstar Inc. Heebner, whose CGM Focus Fund held the top position for the previous 11 quarters, slipped to ninth place with a return of 14 percent. Junk bonds climbed 8.4 percent a year in the span.
“Debt doesn’t have to be a four-letter word,” Soviero, whose fund buys stocks of companies with speculative-grade debt, said in an interview at Fidelity’s Boston offices. “When it works in your favor good things can happen.”
The 47-year-old is betting on more gains after a rally in junk bonds allowed companies to reduce borrowing costs, disagreeing with value investors such as Jeremy Grantham who say debt-laden companies may underperform as the economic rebound loses steam. Soviero took over in mid-2003 and helped guide Leveraged Company to a record 92 percent surge that year. It lost a record 54 percent in 2008 when he underestimated the global economic crisis.
When the economy levels off, bigger companies with stronger balance sheets can often increase earnings faster than weaker rivals, said David Joy, chief market strategist at Boston-based Columbia Management.
“Typically at this point in the cycle you want to migrate towards bigger, higher-quality companies,” Joy, who oversees $350 billion, said in a telephone interview.
Grantham, chief investment strategist at Boston-based Grantham, Mayo, Van Otterloo & Co., and Donald Yacktman, president of Yacktman Asset Management Co. in Austin, Texas, say large companies with stable returns and low debt are the best place to put money now.
“U.S. quality stocks are the least overpriced equities,” Grantham wrote in a January newsletter.
Like junk bonds, the stocks Soviero owns have fared best when interest rates were low, the economy was improving and companies had easy access to credit. As companies paid down debt and refinanced at lower rates, they increased cash flow and attracted equity investors.
“The trade in these stocks has worked for years,” Margaret Patel, who manages more than $1 billion in junk bonds and stocks for Wells Fargo & Co., said in a telephone interview. Patel said the “virtuous circle” that has supported stocks of indebted firms will continue unless interest rates soar or the economy slides back into recession.
The idea for a leveraged-stock fund came from managers in Fidelity’s high-yield bond department, who noticed in the late 1990s that the equities of companies in which they invested often outperformed the junk bonds. Bond returns are limited by changes in interest rates and credit spreads, Soviero said, while “stocks can rise as much as the market drives them.”
Fidelity Advisor Leveraged Company Stock Fund, and the almost-identical Leveraged Company Stock Fund, were created in December 2000. Soviero, who earned a bachelor’s degree in finance from Boston College, joined Fidelity in 1989 as a research analyst. He later worked on several high-yield bond funds before replacing David Glancy, Leveraged Company’s original manager, who left the firm.
“High-yield research is one of Fidelity’s unsung strengths,” James Lowell, editor of the independent Fidelity Investor newsletter in Needham, Massachusetts, said in a telephone interview.
Seeking Revenue Producers
The $14.4 billion Fidelity Capital & Income Fund, with 72 percent of assets in junk bonds, according to Morningstar, beat 98 percent of rivals over the past five years, according to data compiled by Bloomberg. The $8.8 billion Fidelity High Income Fund outperformed 88 percent of peers over the same stretch. Fidelity, the second-largest U.S. mutual-fund manager, oversaw $1.6 trillion as of Feb. 28.
Soviero manages $13.6 billion in six mutual funds. He looks for junk-rated companies that can produce enough revenue to pay down debt or make smart acquisitions, and favors companies in industries whose economics are improving.
“It’s easier to swim with the tide at your back,” said Soviero, who occasionally buys investment-grade companies.
Soviero raised his stake in Freeport-McMoran Copper & Gold Inc. in 2007, according to regulatory filings, after the miner spent $26 billion to buy Phelps Dodge Corp. to become the world’s largest publicly traded copper producer.
To pay for the deal, the Phoenix-based company increased its long-term borrowings, according to data compiled by Bloomberg. Those borrowings shrunk to $7.2 billion as of Dec. 31, 2007, from $11.8 billion on March 31 that year, as Freeport sold assets to pay down debt, Soviero said.
The company’s credit rating was increased twice by Standard & Poor’s and its shares gained 84 percent that year.
“Freeport created great value and became a better strategic player,” Soviero said. The fund no longer owned the stock as of Jan. 31, Bloomberg data show.
The global financial crisis of 2008 triggered a flight to safer assets that crushed the fund, said Shannon Zimmerman, a Morningstar analyst.
“No one wanted an unhealthy balance sheet,” Zimmerman said in a phone interview. The fund is appropriate only for investors willing to tolerate plenty of risk, he said.
Soviero said he was slow to grasp the extent of the unfolding financial crisis.
“That was my mistake,” he said. In the future, he said, he will build up cash in the fund if he sees signs of “cracks” in the credit market.
Junk bonds rallied 58 percent in 2009, their best performance, according to the Bank of America Merrill Lynch U.S. High Yield Master II Index, as the federal government came to the aid of banks and restored confidence in credit markets. Junk bonds are rated Ba1 or below by Moody’s Investors Service and BB+ or below by Standard & Poor’s.
Soviero’s fund rose 60 percent in 2009, 25 percent in 2010, and 5.8 percent this year through April 12.
One of his top holdings, AES Corp., the Arlington, Virginia-based power producer, more than doubled in the 12 months after stocks reached a 12-year low on March 9, 2009. AES’s 8 percent bond maturing in 2017, which is rated below investment grade, returned 50 percent in the same stretch, Bloomberg data show.
Conditions for leveraged companies are still good because they can access credit markets and the economy is improving, Soviero said. Earnings for the S&P 500 companies will reach a record in 2011, Howard Silverblatt, senior index analyst at the New York firm, said in a telephone interview.
Credit Ratings Upgraded
Speculative-grade companies sold an unprecedented $287.6 billion of debt last year and were ahead of 2010’s pace as of April 13 with $100.1 billion of issuance, according to Bank of America Merrill Lynch index data.
Eighty-nine companies with high-yield debt had their credit ratings raised in the first quarter, while 55 saw their ratings cut, New York-based Moody’s wrote in an April report.
Three of Soviero’s top 10 holdings, as of Jan. 31, Phoenix-based On Semiconductor Corp., AES and Service Corp. International, the Houston firm that provides funerals, had their credit ratings increased this year, Bloomberg data show.
Economists surveyed by Bloomberg expect the yield on 10-year U.S. Treasury note to rise to 3.90 percent in the fourth quarter from 3.46 percent.
Not a ‘Blow’
“If rates go up a bit it isn’t going to be a blow to these companies,” said Wells Fargo’s Patel. Many firms that rely on junk bonds have locked in low rates over the last year, so they will be protected if rates climb, Patel said.
If rates rise because of a strengthening economy, companies may be able to offset higher interest costs by lifting prices, Soviero said.
Celanese Corp., a Dallas-based chemical maker and one of the fund’s top holdings, has increased prices on a number of products this year, according to company news releases.
Soviero called the chemical industry a play on the industrialization of China and India. Celanese gets 74 percent of its sales from outside North America, Bloomberg data show.
Investors pulled $1.8 billion from Leveraged Company and Advisor Leveraged Company in 2009 and 2010, following the 2008 losses, according to Morningstar. The pair had more than $9 billion in assets at the end of February, Bloomberg data show.
“This can be a hard sales pitch,” Soviero said. “People look at the balance sheets and want to toss these companies in the trash. One man’s trash is another man’s treasure.”