Fine Fund, Lousy Year
Was a horrific 2008 boringly predictable or a preview of coming disasters?
The past isn't always prologue, but that turns out to be the case often enough that investors can benefit from paying close attention to it. With the third anniversary of the market's March 2009 nadir approaching, I'm gauging whether the managers of the funds I follow have learned from their mistakes. In certain cases, I'm also assessing whether they made any.
For an upcoming issue of Morningstar FundInvestor, I'm researching the current and historical financial-health profiles of the U.S. stock funds that fared the worst during the market's 2007-09 downturn. Among other things, I'm reviewing the pre- and post-crisis portfolio data for these funds to determine if their managers have altered their approaches and, if so, how the composition of their portfolios has changed.
For the subset of domestic-equity managers who own solid long-term track records but fared miserably in 2008, I'm researching the extent to which that year's poor performance owes to unforced errors. That is, gauged relative to their investment processes rather than 2008 returns, did these managers make moves inconsistent with, and riskier than, those that usually result from their strategies?
Ranking among 2008's biggest disasters, the fund shed nearly 60% of its value during that year and landed in the mid-cap blend category's 98th percentile. Painful though that dramatic drop was, horrible performance during a downturn resulting primarily from frozen credit markets shouldn't have surprised anyone familiar with the fund's name.
As its handle suggests, the fund's manager, Tom Soviero, favors firms whose attractive valuations owe in part to the discount the market has applied to their less-than-pristine balance sheets. Whenever credit markets tighten, let alone seize up as they did in 2008, shareholders in the fund should anticipate that it will suffer, perhaps mightily.
Still, even in light of the fund's name, its mandate, and its manager's aggressive style and background as a high-yield credit researcher, should shareholders have anticipated a 2008 nosedive of almost 60%? At a glance, at least, the fund's historical portfolio data suggests that one good answer is…
You have to squint a bit to see it, but the 2008 portfolio data do suggest that at least some investors might have been head-faked by a seemingly temperate list of holdings relative to the fund's nervy (and sometimes nerve-wracking) investment approach.
As with its current portfolio, just a modest portion of assets (roughly 5%) was invested in the market's riskiest stocks types--speculative, distressed, and high-yield securities. Moreover, the vast majority of the fund's April 2008 and October 2008 portfolios (in excess of 80% of assets) comprised firms earning Morningstar Financial Health and Profitability Grades of at least C, too.
Morningstar assigns these grades quantitatively to individual companies. The former takes stock of a company's degree of indebtedness relative to its cash on hand and the strength of its cash flows. The latter judges a firm's historical, normalized, and current return on equity (ROE) figures. Judged according to these metrics, Leveraged Company Stock's 2008 portfolios were substantially invested in firms that enjoyed at least average financial health and profitability.
That's true of the fund's latest portfolio as well.
Viewed through the lens of Morningstar Financial Health and Profitability grades, the fund's 2008 lineup doesn't seem especially risky. Widening the lens to include its debt/capital ratio, though, reveals a feature of the fund that inevitably becomes a bug in some market environments: a portfolio chock-full of firms with above-average debt. Indeed, the average debt/capital ratio of the fund's April 2008 lineup crested 50% versus mid-cap blend and broad-stock market norms in the 30s.
Soviero, a significant investor here, has tacked a bit more cautiously since then. Currently, the fund's lineup runs with a debt/capital ratio of roughly 45%. Its largest sector exposure is a roughly 19% slug of consumer cyclical names; in 2008, nearly a fourth of the fund's assets were allocated to more volatile energy names. Its average market cap has ticked much higher, too, weighing in now at $7.9 billion, or more than twice its average in 2008. It's significantly higher than the fund's historical norm as well.
Overall, though, and through lean times and flush ones, Soviero has stuck with the same aggressive approach that, on his watch of roughly nine years, has generated significant outperformance for investors who are as patient and as tolerant of volatility as he is. Those investors appear to be in short supply, though: In the trailing 10 years through December 2011, the fund's remarkable annualized total return of 12.2% swamps its typical investor's gain. After accounting for money flows into and out of the fund, that shareholder has earned just 1% per annum.
This is a fine fund, but investors need to be able to stick with it through the rocky patches that its mandate makes inevitable.
Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.