A New Winner on the Mutual Fund Charts

Thomas Soviero has replaced Ken Heebner at the top of the mutual fund rankings. His secret: companies with poor credit. Soviero's $4.2 billion Fidelity Advisor Leveraged Company Stock Fund averaged 15 percent annual returns for the 10 years through Mar. 31, best among 3,617 diversified U.S. equity funds tracked by Morningstar (MORN). Heebner, whose CGM Focus Fund (CGMFX) held the top position for the previous 11 quarters, slipped to ninth place with a return of 14 percent. "Debt doesn't have to be a four-letter word," says Soviero in an interview at Fidelity's Boston offices. "When it works in your favor, good things can happen."

Soviero buys stock in junk-rated companies that can produce enough revenue to pay down debt or make smart acquisitions. He favors industries whose economics are improving. "It's easier to swim with the tide at your back," says Soviero, who occasionally buys investment-grade companies.

Like junk bonds, the stocks Soviero owns fare best when interest rates are low and companies have easy access to credit. As the companies pay down debt and refinance at lower rates, they increase cash flow and attract equity investors. "The trade in these stocks has worked for years," says Margaret Patel, who manages more than $1 billion in junk bonds and stocks for Wells Fargo (WFC). Patel says the "virtuous circle" that has supported stocks of indebted companies will continue unless interest rates soar or the economy slides back into recession.

Soviero raised his stake in Freeport-McMoRan Copper & Gold (FCX) in 2007, according to regulatory filings, after the miner spent $26 billion to buy Phelps Dodge 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. As Freeport sold assets to pay down debt, 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 says.

The idea for a leveraged-stock fund came from managers in Fidelity's high-yield bond department who saw 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 says, while "stocks can rise as much as the market drives them." One of his top holdings, AES (AES), the Arlington (Va.)-based power producer, more than doubled in the year after stocks reached a 12-year low on Mar. 9, 2009. AES's 8 percent bond maturing in 2017, which is rated below investment grade, returned 50 percent in the same stretch, according to data compiled by Bloomberg.

Soviero, 47, 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 fund's original manager, in 2003. Soviero helped guide Leveraged Company to a 92 percent surge that year. In 2008 it lost 54 percent. Soviero says he was slow to grasp the extent of the unfolding financial crisis: "That was my mistake." In the future, he says, he plans to build up cash in the fund if he sees signs of "cracks" in the credit market. His fund rose 60 percent in 2009, 24 percent in 2010, and 7.1 percent this year through Apr. 15.

Conditions for leveraged companies are still good because they have access to credit markets and the economy is improving, Soviero says. Eighty-nine companies with high-yield debt had their credit ratings raised in the first quarter, while 55 saw their ratings cut, Moody's wrote in an April report. Three of Soviero's top 10 holdings as of Jan. 31—Phoenix's ON Semiconductor (ONNN), AES, and Service Corp. International (SCI), the Houston company that operates funeral homes—had their credit ratings increased this year, Bloomberg data show. "This can be a hard sales pitch," Soviero says. "People look at the balance sheets and want to toss these companies in the trash. One man's trash is another man's treasure."

The bottom line: Using low credit ratings as a guide to finding undervalued stocks, Soviero has averaged 15 percent annual returns for the past 10 years.

    Before it's here, it's on the Bloomberg Terminal.