Investing in companies with large amounts of debt and low credit quality can be risky, but with risk comes the potential for reward.
Tom Soviero, manager of the Fidelity Leveraged Company Stock Fund, wades in these risky waters looking for companies with the potential to improve. Viewpoints sat down with Soviero to discuss his outlook for leveraged companies today. Learn why he thinks it may be time to be defensive, and how he is investing in consumer trends and global industrial companies.
Q: You invest in stocks of companies with a high degree of economic sensitivity. Where do you see the U.S.—and leveraged equities—currently in terms of the business cycle and the post-crisis recovery?
Soviero: For the first time in three years, my outlook for leveraged equities is cautious. On the one hand, the U.S. economy is in recovery mode, and access to the capital markets—both debt and equity—is quite strong. However, this optimism has to be tempered by structural problems confronting the European Monetary Union—as witnessed by the bailout in Cyprus—and mixed signs out of China while that country tries to engineer a moderate slowdown in growth without creating social unrest. These issues, combined with political gridlock in Washington, make it hard to argue for any kind of valuation expansion for the overall market. That leaves one to rely on corporate earnings growth, and the outlook there is for mid-single-digit growth in 2013—at best—due to slow revenue growth and margin pressures from rising health care and other costs.
In response, I expect to continue focusing on globally competitive industrial firms, and on consumer-related companies that should benefit from a slowly recovering domestic economy and from the growing middle class in developing nations. I remain biased toward names that are in a position to grow their profits and cash flow for company-specific reasons, without undue reliance on growth abroad. I prefer companies that are well managed and are positioned to generate free cash flow that will ultimately help them reduce debt and grow shareholder value.
The geopolitical concerns I’ve mentioned, along with dangerous debt levels equal to our gross domestic product [GDP] and no help from Washington, argue for a more defensive posture. I am even considering keeping more-elevated cash levels than in the past, in an effort to help cushion against risk aversion in the market and to build up “dry powder” for attractive opportunities down the road.
Q: Recently, interest rates moved sharply higher very quickly. How does the prospect of potentially higher rates influence the leveraged companies in which you invest, particularly if they can’t borrow money at the same low rates?
Soviero: During the past three years, there’s been an enormous amount of new issuance in the high-yield market, as leveraged companies have refinanced their obligations with fixed-cost debt at low prevailing yields. As such, the balance sheets of many firms are in good shape and, thus, the companies should not be unduly impacted by rising interest rates. At the same time, each corporation’s situation is unique. Nobody likes to see interest rates rise 40 basis points [0.40%] in two weeks, as they did in June, but I think that was an anomaly. It’s also important to note that rising rates are usually a sign of an improving economy, which leveraged companies love, because better economic growth typically translates into higher sales. At the end of the day, though, as I said, the eventual effects of rising interest rates will vary company by company, in my opinion.
Q: What areas of the market have you favored or avoided recently?
Soviero: About 18 months ago, I became concerned about the macroeconomic background in China, feeling that the country would have a difficult time maintaining what was at that time a torrid pace of growth, which was helping to sustain strength in the global economy. As a result, I avoided companies with exposure to Chinese infrastructure growth, including steel, aluminum, and copper companies. Instead, I fashioned the portfolio to be more U.S.-centric, favoring consumer discretionary names, including major automotive manufacturers Ford and General Motors. The business fundamentals of these companies have shown dramatic improvement, as extremely low interest rates have kept consumer financing costs low. Additionally, Ford and GM had the benefit of an inherent replacement cycle as the average age of cars on the road in the U.S. approached 11 years, a high that hasn’t been seen in many decades. More recently, the companies were better positioned in terms of cost structure than they were several years ago, and have more exposure to a burgeoning middle class in emerging countries like China, where consumers have been seeking status by purchasing American cars.
I also have sought to take advantage of a manufacturing renaissance in the U.S., where companies are benefiting from cheap prices for oil and natural gas used in production, and from a labor market that has seen virtually no wage increases during the past 10 years. Overall, I prefer investing in companies with concrete assets at their disposal, because the firms then have something to fall back on to sell if they encounter difficulties managing their leverage. That’s one of the reasons I’ve underweighted financials; those companies are difficult for me to evaluate, given the obscure nature of many of the assets they carry on their books.
Q: What has been driving performance in your fund recently?
Soviero: It’s really come down to the performance of my best ideas. For example, during the past year, the main driver of the fund’s outperformance was its biggest position, chemicals manufacturer LyondellBasell Industries. We identified this opportunity early on, well before the story was understood by the overall market. Lyondell emerged from bankruptcy in 2010, and, at the time, our high-yield credit analyst Rick Malnight identified the company as a strong candidate for profound fundamental improvement. What’s driven this stock has been the shale natural gas boom in the United States. Lyondell uses natural gas in the production of its main product, ethylene, while most of its competitors rely on oil for their processing. A surge in natural gas supply led to sharp reductions in the price of that commodity, particularly relative to oil. This price drop resulted in a major cost advantage for Lyondell, and the company’s stellar management team has executed well in translating that into strong returns.
Q: As you celebrate your 10th anniversary running Fidelity Leveraged Company Stock Fund, what have you learned from the various cycles, particularly the 2007–08 crisis?
Soviero: Mainly to take profits more quickly and sell out of a stock more rapidly if the company’s business fundamentals take a turn for the worse. One of the cornerstones of my approach is to try to limit turnover of the fund’s holdings; I’m a long-term investor. Before 2008, I had enjoyed a good run with the fund. But, as Bill Gates has said, success can be a lousy teacher. It seduces people into thinking they can’t lose. That’s essentially what happened to me in 2008. As things were falling apart, I didn’t move fast enough to reposition the portfolio, and its performance suffered. Fortunately, I’ve made back what I lost in 2008—and much more—but the experience helped me evolve as a portfolio manager.
Q: Why is leverage a good thing for a company, if you can pick the right one?
Soviero: I like to use a real estate analogy. Let’s imagine that you thought real estate on Cape Cod was cheap but would appreciate a great deal going forward. To get the highest return on your investment, you would want to borrow as much as possible. For example, you could pay $1 million cash for a house, or you could put down $100,000 and borrow the remaining $900,000. Then, imagine this house rose in value to $2 million within two years, and you chose to sell it. If you paid cash, you would make $1 million profit on your $1 million investment, for a return of 100%. However, if you had borrowed $900,000, you would reap a return of 1000%. That’s because you invested only $100,000 to earn a profit of $1 million after paying off the loan and some relatively small interest costs. Leveraged equities work in the same way, as companies borrowing money can magnify their returns on equity.
If I can find winners for the fund—companies that combine some sort of beneficial tailwind or catalyst for their business prospects, the right kind of management teams, or positive backdrops for their sector—then, as I like to say, debt doesn’t have to be a four-letter word. Rather, it can be a propellant for returns. This is the same theory behind leveraged buyouts [LBOs], wherein returns can be compounded by investors using debt prudently. Some have called this fund a public version of an LBO shop for any investor, and I think that’s a fair analogy.