(PUB) Investing 2015

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11 Morningstar FundInvestor March 2015
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
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
Stock Funds With Highly Indebted
Portfolios
Red Flags | Kevin McDevitt
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.