Thomas Soviero uses a real estate analogy to illustrate the rationale behind the Fidelity Leveraged Company Stock Fund (FLVCX) that he runs.
A person who uses mostly borrowed money to purchase a house in a market he expects to heat up can sell it for a big profit later on if the area becomes desirable, the portfolio manager explains. Similarly, the companies Soviero buys can pay off if they churn out cash and reduce their debts.
“You could get magnified returns when the financial leverage starts working in your favor,” Soviero says.
Soviero looks for what he judges to be attractively valued stocks of companies that issue high-yield, or so-called junk bonds, or that carry other debt. He hunts for those with strong cash flow using a formula that takes into account a business’s earnings before taxes, depreciation and amortization, as well as its capital expenditures.
Companies do not have to profitable to gain entrance to the portfolio, says Soviero, who’s willing to buy those he thinks will eventually start generating earnings. He also keeps an eye out for a catalyst, like a new product, that can drive a stock higher.
About 150 companies with market caps of $1 billion to $10 billion wind up in the fund, but the top 50 holdings account for more than half its assets, Soviero says. This concentration leads to the best value for shareholders because it puts “the most money in your best ideas,” he says.
Since Soviero took over Leveraged Company Stock in July 2003, he has kept it out ahead of the competition by a comfortable margin. The $3.5-billion fund was up 17.5% last year, compared to a 9.7% gain by its mid-cap blend fund peers, and a 4.9% return by the Standard & Poor’s 500 index. The Fidelity offering returned 42.1% on average for the three years ended in December. Similar funds rose 19.9% during that span, and the index traded up 14.4%.
Soviero cited Service Corp. International Inc. (SCI), a funeral home operator, as an example of a typical investment for the fund. The company generates “very healthy free cash flow,” says Soviero, who was also drawn to Service Corp. because of a new management team. “They’re approaching the business with a different mind-set that’s healthy for overall revenue and earnings growth,” he says.
Service Corp. held the No. 4 spot in the portfolio at the end of the third quarter last year. Another of the fund’s top ten stocks at that time (Soviero declined to discuss his year-end holdings) was OMI Corp. (OMM), which ships oil and natural gas with a fleet of tankers.
The Stamford, Ct.-based company looked good because its stock was trading for about six or seven times projected earnings, making it cheap relative to the overall market, Soviero says. He adds that OMI generated lots of free cash and had been aggressively buying back its shares.
When it comes to selling, Soviero will trim a position or eliminate it entirely if a company’s financial fundamentals erode, if a stock’s valuation becomes too rich, or if the shares reach the price target he sets for them at a time when the company’s earnings haven’t risen dramatically.
But, he points out, “I don’t trade a whole lot.” That’s borne out by the fund’s turnover rate, which clocked in at 16% last year, compared to 62% for its peers.
A potential pitfall of investing in the fund, Soviero agrees, is that shareholders could lose money if its holdings fail to repay their debts. The fund’s concentrated portfolio can make it risky, too, he says.
Leveraged Company Stock is “a bit more volatile on a day-to-day basis” than other funds, the portfolio manager says. A look at some other data on the fund confirms that. The fund’s three-year standard deviation, which measures the variability of its returns, clocked in at 18.07 last year, versus 11.87 for its peers. In addition, its beta, a gauge of a fund’s sensitivity to changes in the market, was 1.65, compared to 1.13 for similar offerings.
To compensate for any rough patches, he tries to guess right over the long term, and consequently encourages investors to stay in the fund over the long run, Soviero says.
To identify investment candidates for the fund, Soviero relies primarily relies on research from Fidelity’s fixed-income department, and also gets ideas from its stock analysts. Soviero himself has a background in junk bonds, having been named Fidelity’s director of high-yield research in 1992.
Soviero, who began managing institutional high-yield accounts in 1994, also runs several other Fidelity funds, including the Fidelity Advisor High Income Advantage Fund (FAHDX), which invests in junk bonds.
Looking at the junk bond market in 2006, Soviero thinks it’s “pretty fully valued.” Still, he’s not pessimistic about the sector, because he sees its fundamental underpinnings as sound. Among other things, default rates are fairly low, and companies in general have relatively healthy balance sheets, he says.
Soviero is more optimistic about stocks than high-yield bonds, though. He envisions equities benefitting from the continued growth of the U.S. economy, and from what he describes as a “very healthy” environment for mergers and acquisitions in which highly leveraged companies stand to get bought up.
Contact Bob Keane with questions or comments at: email@example.com.