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A Debt Premium?

A good year for leverage has been a great year for this fund.

The books haven't yet closed on 2012, but the attributes that have led to success for mutual funds this year are coming into view. Among U.S. stock funds, bigger has mostly been better so far in 2012, with only the mid-cap value category surpassing Morningstar's three large-cap peer groups through the close of October. Barring a reversal of fortune between now and New Year's Eve, leverage will also rank among the year's performance contributors. Thus far in 2012, funds that favor more heavily indebted firms have fared better, on average, than those with lineups focused on financially healthier companies.

Crunching the Numbers
In the year to date through October, the Credit Suisse Leveraged Equity Index has outpaced the S&P 500 by roughly 2 percentage points. Leverage comes with the territory in the financials sector, and it's been the best-performing area of the market this year. Indeed,  Financial Select Sector SPDR (XLF) has sailed past the S&P 500 by more than 11 percentage points so far in 2012.

Year-to-date mutual fund returns offer further evidence of a debt premium in 2012. Through September, the U.S. stock fund universe's median debt/capital ratio is approximately 33.5. On average, funds whose debt/capital ratios tick above that figure place in their respective category's top half. Those with below-median ratios rank in the bottom half of their peer groups. The typical U.S. stock fund with an above-median ratio has gained roughly 13% this year, too, outpacing the below-median norm by roughly 2 percentage points.

Case Study and an Exception to the Rule
Not all funds that traffic in leveraged companies have met with success this year, of course. Gabelli Value (GABVX) and Ken Heebner's  CGM Focus  are in their categories' bottom halves despite debt/capital ratios well above the U.S. stock fund median. And while on average higher debt/capital ratios have been associated with higher returns this year, no single factor accounts for any fund's performance.

Still, if 2012 has so far been a good year for leverage, it's been a great one for  Fidelity Leveraged Company Stock (FLVCX). Its gain of nearly 22% through the end of October places in the mid-blend peer group's second percentile. The fund is hardly a typical mid-blend offering, a point underscored by its official benchmarks, neither of which is a mid-cap bogy: the S&P 500 Index and the Credit Suisse Leveraged Equity Index. The fund has also surpassed those yardsticks this year, besting the S&P 500 by more than 5 percentage points and the Credit Suisse bogy by more than 7 points through October. (The fund's success has come, moreover, despite its modest allocation of just 6.4% of assets to financial stocks.)  

Leveraged Company Stock's latest portfolio lives up to the fund's name with a debt/capital ratio of 44.3; the comparable figure for the S&P 500 is 35.6. That's typical here. Led by former high-yield manager Tom Soviero since July 2003, the fund is essentially a poster child for vehicles specializing in the equity of deeply indebted firms. As of July 2012--the date of the fund's most recently disclosed portfolio--just nine other U.S. stock funds had higher debt/capital ratios.

Live by Leverage ...
Plenty of risk comes with the territory that Soviero targets. The fund got utterly crushed in 2008 when frozen credit markets took a severe toll on the stock prices of companies that rely most heavily on easy access to the capital markets. That year, Leveraged Company Stock lost more than half its value and placed in the mid-blend category’s 98th percentile, lagging the S&P 500 by nearly 18 percentage points.

That showing, in a word, was grim. It was also largely predictable, given the kinds of companies it gravitates toward. The fund's stellar 2009 campaign wasn't a surprise, either. Amid that year's flight to risk, Leveraged Company Stock rocketed into the category's top decile, notching a gain of nearly 60% and topping the S&P 500 by some 33 percentage points.

Clearly, this fund isn't for the faint of heart. Yet, as wildly volatile as it is, performance patterns here have been consistent. The fund's 2008 showing was precisely what you would expect for a vehicle loaded up with leveraged firms. And when investors embrace riskier equities, the fund typically soars. That pattern is reflected in the fund's upside and downside capture ratios. In the trailing 10-year period through October, Leveraged Company Stock has earned nearly 1.7 times the S&P 500's gains while suffering approximately 1.4 times its losses.

Valuing Flawed Companies
Soviero has deftly navigated one of the market's riskiest areas thanks largely to skillful valuation work. The fundamentals of the companies he targets, after all, aren't strong. These are issuers of high-yield debt, or firms whose balance sheets have been leveraged up in other ways. Just 13% of assets are invested in companies Morningstar Equity Research believes possess wide moats. The comparable figure for the benchmark S&P 500 Index is 44%. Soviero's lineup is also less profitable, on average, than the S&P's companies. As gauged by the revenue per share, his holdings' growth characteristics are poorer on average, too.

When that's your fishing hole, a knack for separating values from value traps is essential, and Soviero appears to have it. Between his July 2003 arrival and October 2012, the fund's cumulative increase of roughly 160% more than doubles the S&P 500's performance in the period. It bests the mid-blend norm by approximately 65 percentage points. In the 53 rolling five-year periods spanning Soviero's tenure, the fund has bested the S&P 71% and the mid-blend norm 60% of the time, too. Performance swings have been far wider than either of those yardsticks, but the fund's Sortino ratio--a metric that penalizes poor down-market performance--surpasses both bogies' marks.

Risky by Design
That showing aside, the fund comes with important caveats. Its performance owes in part to muted interest rates in two of the past decade's three market cycles. The Fed funds rate was low when Soviero arrived, and it's been remarkably low during the past four years. That's an attractive environment for the kinds of companies he owns. The fund's 2008 showing, however, shows what happens when those firms' access to capital is constricted. The fund would suffer if interest rates spike and credit spreads widen sharply, too.

Those risks are baked in here, though, and the fund's outsize success over the long haul shows that Soviero has made the most of a mostly good situation for his companies. Along with his substantial investment alongside shareholders here and an attractive price tag of just 0.85%, the fund's track record contributes to Leveraged Company Stock's Morningstar Analyst Rating of Silver. Yet even if its future is as bright as its past, the fund is unlikely to earn a Gold rating. As skilled as Soviero has been at executing its strategy, the fund's performance patterns, while consistent over time, have been too volatile for too many investors.

During the trailing 10 years through October, Leveraged Company Stock has delivered an annualized gain of more than 16%--the highest 10-year return in the U.S. stock fund universe. However, after accounting for money flows into and out of the fund, Morningstar estimates that the typical investor here earned less than 3% per annum in that stretch.

That isn't Soviero's fault--he's stuck to, and succeeded with, the same strategy throughout his tenure. As the fund's top-percentile showing thus far in 2012 attests, moreover, he remains capable of making the most of a market environment favorable to his approach. Nonetheless, the fund remains suitable only for a narrow sliver of a portfolio, and only for patient, volatility-tolerant investors who are willing to ride out its inevitable lows in anticipation of benchmark-besting gains. 

Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.