(PUB) Investing 2016

11

May 2016

Morningstar FundInvestor

Funds Investing in Heavily Indebted Companies Red Flags | Gretchen Rupp

FPA US Value FPPFX Greg Nathan became the new lead manager here as of September 2015 , coinciding with previous lead manager Eric Ende’s retirement. Nathan hasn’t wasted time, creating wholesale changes at FPA US Value (previously named FPA Perennial). He cut his teeth as an investor at contrarian-allocation fund FPA Crescent FPACX and appears to carry some of that mind-set to make his mark at this fund. As of March 2016 , the debt/capital ratio is about 80% higher than it was five years earlier. Picks like Tempur Sealy TPX and Daimler AG DAI contribute to the average debt ratio increase. In addition, Nathan invests about 20% of the portfolio in media stocks such as Discovery Communications DISCK . Although the media picks have had healthy ROIC s in the past, free cash flow growth has generally been less steady at his sector picks recently. American Century Heritage Fund TWHIX This fund’s average debt/capital ratio increased 20% over the 12 months through December 2015 . In addition, more than half of the fund’s picks have a debt/capital ratio that exceeds the mid-cap growth Morningstar Category average, demonstrating a consistent increase in debt over many of the fund’s approximately 100 holdings. For example, aluminum- can producer Ball Corporation BLL has been a holding in the fund since 2014 . The company announced its intent to buy competitor Rexam PLC REX in early 2015 . While the acquisition has the potential to create value, both interest coverage and ROIC s declined significantly during 2015 . Longleaf Partners LLPFX Longleaf Partners’ Morningstar Analyst Rating was downgraded to Neutral from Silver because of missteps from several heavily weighted stocks. In addition to stock-price declines from Wynn Resorts WYNN and Chesapeake Energy CHK , the fund has owned Scripps Networks SNI since 2014 . Scripps has healthy interest coverage, but its quick ratio (the ratio of current assets to current liabilities) and ROIC s have been on the decline while long-term debt increased during 2015 . K Contact Gretchen Rupp at gretchen.rupp@morningstar.com

Most U.S. companies have taken advantage of a low- interest-rate environment since the financial crisis and have steadily layered on debt. Indeed, the average debt/capital ratio at large-cap funds has increased just over 20% during the five years through 2015 . Meanwhile, growth-oriented funds have seen their debt/capital rise by about 30% over the same period. Some investors might be less concerned when the long- term debt is financed at record-low rates. However, additional leverage can reduce a company’s flexibility in the future. Specifically, if high debt levels remain when the recession arrives, refinancing would likely take place during a less-attractive rate environment. And future cash flows, necessary for debt payment, are at risk. In addition, management teams that accept a return on invested capital below normalized rates (because the cost of borrowing is low) potentially damp future growth rates. Low rates also enable a spike in mergers, but those represent another risk. As a result, fund managers decide if they accept the risk of temporarily higher levels of debt in exchange for future cost savings and cash flow growth. We’ve selected three funds whose average portfolio’s debt/capital ratio ranks in the highest decile within the Morningstar 500 U.S. equity funds. These funds’ most recent portfolio data available show debt levels at least 20% higher than levels 12 months prior. There is certainly more nuance within the capital structure than just a portfolio’s average debt/capital ratio, so, from here, other security-level metrics considered include interest coverage, short-term asset/liability ratios, and free cash flows.

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.