(PUB) Investing 2016

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11 Morningstar FundInvestor May 2016
Most U.S. companies have taken advantage of a low-
interest-rate environment since the financial crisis
and have steadily layered on debt. Indeed, the average
debt/capital ratio at large-cap funds has increased
just over 20% during the five years through 2015.
Meanwhile, growth-oriented funds have seen their
debt/capital rise by about 30% over the same period.
Some investors might be less concerned when the long-
term debt is financed at record-low rates. However,
additional leverage can reduce a company’s flexibility
in the future. Specifically, if high debt levels remain
when the recession arrives, refinancing would likely
take place during a less-attractive rate environment.
And future cash flows, necessary for debt payment, are
at risk. In addition, management teams that accept
a return on invested capital below normalized rates
(because the cost of borrowing is low) potentially
damp future growth rates.
Low rates also enable a spike in mergers, but those
represent another risk. As a result, fund managers
decide if they accept the risk of temporarily higher
levels of debt in exchange for future cost savings and
cash flow growth.
We’ve selected three funds whose average portfolio’s
debt/capital ratio ranks in the highest decile within
the Morningstar 500 U.S. equity funds. These funds’
most recent portfolio data available show debt levels
at least 20% higher than levels12 months prior. There
is certainly more nuance within the capital structure
than just a portfolio’s average debt/capital ratio,
so, from here, other security-level metrics considered
include interest coverage, short-term asset/liability
ratios, and free cash flows.
FPA US Value FPPFX
Greg Nathan became the new lead manager here
as of September 2015, coinciding with previous lead
manager Eric Ende’s retirement. Nathan hasn’t
wasted time, creating wholesale changes at FPA US
Value (previously named FPA Perennial). He cut his
teeth as an investor at contrarian-allocation fund FPA
Crescent FPACX and appears to carry some of that
mind-set to make his mark at this fund. As of March
2016, the debt/capital ratio is about 80% higher
than it was five years earlier. Picks like Tempur Sealy
TPX and Daimler AG DAI contribute to the average
debt ratio increase. In addition, Nathan invests about
20% of the portfolio in media stocks such as Discovery
Communications DISCK. Although the media picks
have had healthy ROICs in the past, free cash flow
growth has generally been less steady at his sector
picks recently.
American Century Heritage Fund TWHIX
This fund’s average debt/capital ratio increased
20% over the 12 months through December 2015. In
addition, more than half of the fund’s picks have
a debt/capital ratio that exceeds the mid-cap growth
Morningstar Category average, demonstrating a
consistent increase in debt over many of the fund’s
approximately 100 holdings. For example, aluminum-
can producer Ball Corporation BLL has been a
holding in the fund since 2014. The company
announced its intent to buy competitor Rexam PLC
REX in early 2015. While the acquisition has the
potential to create value, both interest coverage and
ROICs declined significantly during 2015.
Longleaf Partners LLPFX
Longleaf Partners’ Morningstar Analyst Rating
was downgraded to Neutral from Silver because of
missteps from several heavily weighted stocks.
In addition to stock-price declines from Wynn Resorts
WYNN and Chesapeake Energy CHK, the fund has
owned Scripps Networks SNI since 2014. Scripps has
healthy interest coverage, but its quick ratio (the
ratio of current assets to current liabilities) and ROICs
have been on the decline while long-term debt
increased during 2015. K
Contact Gretchen Rupp at
Funds Investing in Heavily
Indebted Companies
Red Flags | Gretchen Rupp
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.