(PUB) Investing 2015

March 2015

Morningstar FundInvestor

11

Stock Funds With Highly Indebted Portfolios Red Flags | Kevin McDevitt

by a large cash stake, which was 20% as of September 2014 .

Osterweis OSTFX (52.7%) This fund also used to damp volatility by holding more cash than most peers. But management has cut cash since 2011 ’s third quarter from about 19 . 0% to 4 . 4% of assets as of December 2014 . This helped the fund better capitalize on the subsequent equity rally to a degree, but it is more vulnerable to corrections. That’s especially true given the portfolio’s 52 . 7% average debt/capital ratio. The fund fared the worst of this group during the high-yield correction in 2015 ’s second half, losing 1 . 6% versus the S & P 500 ’s 6% gain. First Eagle Fund of America FEAFX (51.6%) This fund’s managers look for companies undergoing some sort of change, such as new management, a merger, or a new strategic direction. They clearly don’t mind companies with leveraged balance sheets. This has helped the fund generate the mid- blend category’s highest current return on equity: 27 . 6% . That high ROE also stems from the fund’s big positions in health-care and technology firms, which were 17 . 5% and 24 . 3% of the latest portfolio, respectively. It’s worth noting that valuations are considered fairly rich in both sectors, with that risk layered on top of a highly leveraged portfolio. Janus Contrarian JSVAX (47.4%) This is the only non-mid-cap fund in the top four. But all-cap Janus Contrarian, with a current average debt/ capital ratio of 47 . 4% , has been on the large-cap/ mid-cap border since Dan Kozlowski took the helm in July 2011 . Kozlowski invests far more heavily in small- and mid-cap companies than do most large- blend category peers. He also tolerates more debt than most peers and his predecessor. Since he came on board, the fund’s average debt/capital has climbed from 32 . 1% to its current level. This fund enjoyed excellent returns during Kozlowski’s first three calendar years, but it courts far more risk than most large-blend funds. œ Contact Kevin McDevitt at kevin.mcdevitt@morningstar.com

You’d think the natural response to a credit crisis would be to cut debt. But there’s far more debt sloshing around the world than there was in 2007 . The McKinsey Global Institute recently published a report showing that global debt has increased by $57 trillion since then. Governments and companies have led the way. U.S. companies issued a then-record $1 . 49 trillion in bonds in 2013 , only to surpass that in 2015 with more than $1 . 5 trillion in issuance. All this borrowing is showing up in U.S.-equity fund portfolios. Vanguard Total Stock Market Index ’s VTSMX average debt/capital ratio hit a record 37 . 5% in December 2014 . In June 2007 it was 35 . 3% . Keep in mind that funds with high debt/capital ratios fared far worse during the 2007 – 09 credit crisis than their peers. That was also the case in the second half of 2014 when falling oil prices led to a correction in the high-yield bond market. The highest debt/capital ratios tend to be found among mid-cap funds. Mid-growth funds in particular have the highest average debt/capital ratio, at 41 . 5% , among the nine major U.S. equity Morningstar Catego- ries. (Large-growth funds have the lowest at 32 . 2% .) Below are the four funds from the Morningstar 500 with the highest average debt/capital ratios, three of which are mid-cap offerings. Weitz Hickory WEHIX (53.8%) Managers Wally and Drew Weitz have a high toler- ance for leveraged balance sheets. This fund currently has the mid-blend category’s highest average debt/ capital ratio of 53 . 8% . This leverage may seem at odds with their preference for capital-light business models, but these companies often grow through acquisition or optimize their balance sheets relative to cash flows with the intent of increasing returns on equity. Such balance-sheet risk is offset somewhat

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.