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When Debt Was Poison

Debt played a leading role determining 2008's losers and this year's winners.

The market takes a balanced view of the value of a company over time but in the short term it often focuses on just one factor. In the late 1990s it was rapid growth. If a firm's top line was skyrocketing, so was its stock price--even if it had an abysmal balance sheet and no foreseeable earnings prospects. Over the past two years that single factor has been debt. In 2008, firms with less-than-perfect balance sheets saw their shares trampled. John Rogers at Ariel Investments had to be pulling his hair out in 2008. All his funds were full of cheap, profitable firms with strong cash flows and manageable, but above-average, debt levels. They got clobbered in 2008, with  Ariel (ARGFX) losing 48.3%.

But when investors realized there wouldn't likely be another depression and the banking system hadn't been destroyed, those shares rallied dramatically. Fund performance reflected this. And last year's pariahs, like Rogers, have been this year's heroes: Ariel is up 51.6% for the year to date in 2009.

We did a deep dive to quantify the impact of various factors on fund performance in the recent bear market and subsequent rebound. We found a clear pattern. Then we looked to see if this had any correlation with long-term success to determine what it all means to investors.

How We Ran the Study
We took the 235 domestic-equity funds in the Morningstar 500 and looked at the quality and valuation of their underlying holdings to see what impact this had on performance in 2008's downdraft and then in this year's rebound. We used six factors: debt/capital ratio, Morningstar Financial Health Score, free cash-flow yield, the percentage of firms making a profit, Morningstar Profitability Score, and price/earnings ratio. The first two measure debt and liquidity; the next three represent operational strength and profitability; the last shows how cheap a portfolio is.

We ranked funds in quintiles for each factor, analyzed each independently, and then created an overall score for each fund based on the sum of all six factors. We looked at mid-2008 portfolios to capture each fund's profile just prior to that year's biggest swoon. We also looked at early 2009 portfolios to see how the same funds were positioned going into this year's rebound. Then we cross-referenced these fundamental factors with the same fund's performance in 2008 and for the year to date through Sept. 22, 2009.

To see the table, click here.

What We Found
Funds in the Morningstar 500 hardly ever changed their portfolio style, and they landed in one of three broad groups: high quality and low debt, high quality but high debt, and low quality. There was tremendous consistency between the quintile scores from mid-2008 and early 2009. Funds that favored quality in the past continued to do so, while those that dabble in junk didn't change their stripes.

High Quality, Low Debt
The first group of funds has consistently owned high-quality, reasonably priced portfolios full of profitable companies. They held up better than all others in 2008's downdraft but haven't kept pace so far in 2009's rally.  Vanguard Dividend Growth (VDIGX), for example, was a relative stalwart in 2008 with its quality portfolio, losing 25.6% while the S&P 500 was shedding 37% of its value. It has a double-digit gain for the year to date in 2009, but it lags nearly all of its category rivals.

This group consistently scored in the best quintile for all factors and had the best overall scores by far. That was no surprise here. Funds like  Sequoia (SEQUX),  Jensen Fund (JENSX), and  FAM Value (FAMVX) have long used prudent, Buffett-inspired strategies that emphasize quality and the preservation of capital. A few have big cash stakes, but that by itself didn't explain their downside chops last year. Others, like  Vanguard Primecap (VPMCX),  Amana Trust Growth (AMAGX), and  Chase Growth (CHASX), have excelled, buying industry leaders when their shares temporarily dip. These funds outperformed by so much in 2008 that even though they've lagged lately their trailing one-year returns are still topnotch.

Low Quality, High Debt
On the opposite end of the spectrum are funds that are comfortable holding speculative fare and willingly load up on firms with dodgy balance sheets. These are the last companies you want when a recession hits.  Schneider Value  is the poster child for this group. It scored in the bottom quintile on every factor. It carries 50% more debt than the S&P 500 Index, has negative free cash flow, and many of its firms are losing money.  Janus Venture (JAVTX) and the aptly named  Fidelity Leveraged Company Stock (FLVCX) are cut from the same cloth. All three funds got crushed in 2008, shedding more than half their value, but have roared back so far in 2009, gaining 45% or more. But many funds in this group dug such big holes for themselves last year that their trailing one-year returns are still subpar.

High Quality, but High Debt
The final group shows that debt trumped every other factor in 2008. These funds have always held cheap firms with strong cash flows and solid profitability but none of that mattered in 2008 because they also have outsized debt loads.  Ariel Appreciation (CAAPX) and  Neuberger Berman Partners (NPRTX) are extreme examples. In 2008, nearly every firm in their portfolios was generating a profit, landing them at the top of our sample. Their free cash flow, Morningstar Profitability, and P/E scores were also among the best of the group. Their debt-related scores, however, were in the worst quintile. So, despite owning the cheapest stocks with the highest profitability and strongest cash flows, both got obliterated in 2008, losing as much as or more than the funds in the lowest-quality group. Ariel Appreciation dropped more than 40%, and Neuberger Berman Partners shed more than half its value in 2008.

But both funds scored better on the profitability, free cash flow, and valuation metrics than nearly all of the funds in the high-quality group, including such 2008 stalwarts as Sequoia, Amana Trust Growth, and Vanguard Primecap. And the market has noticed. Sequoia and Amana Trust Growth lost less than 30% last year and have gained about 20% so far in 2009. But Ariel Appreciation and Neuberger Berman Partners are up about 50% in 2009 and their one-year returns are now better than most of the highest-quality funds'.

This profile repeats to a lesser extent with the rest of the third group.  Weitz Partners Value (WPVLX),  Dodge & Cox Stock (DODGX),  Vanguard Windsor (VWNDX), and  Legg Mason Value (LMVTX) all have top-quintile free cash flow and P/E scores but below-average debt profiles. They suffered disproportionately in 2008 but have roared back.

Funds with debt as the only strike against them have outperformed those facing many challenges as well as the high-quality group lately, indicating the market is again valuing stocks on several fundamental factors, not just debt levels.

Near-Term Is Noise
Good managers don't ditch their strategy because of extreme market conditions and you should follow suit. When we cross-referenced recent events with long-term returns we found no major correlation. Representatives from all three groups have topnotch 10- and 15-year returns, proving there are several ways to reach the same destination. The key is to align your risk tolerance with your fund's style so you're able to stick in for the duration. Or, better yet, own all three types of funds as complementary pieces in a diversified portfolio.

This article previously appeared in the October 2009 issue of Morningstar FundInvestor. Clickhereto learn more. Ideas Week
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Michael Breen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.