Debt played a leading role determining 2008's losers and this year's winners.
The market takes a balanced view of the value of a company over time but in the short term it often focuses on just one factor. In the late 1990s it was rapid growth. If a firm's top line was skyrocketing, so was its stock price--even if it had an abysmal balance sheet and no foreseeable earnings prospects. Over the past two years that single factor has been debt. In 2008, firms with less-than-perfect balance sheets saw their shares trampled. John Rogers at Ariel Investments had to be pulling his hair out in 2008. All his funds were full of cheap, profitable firms with strong cash flows and manageable, but above-average, debt levels. They got clobbered in 2008, with Ariel
But when investors realized there wouldn't likely be another depression and the banking system hadn't been destroyed, those shares rallied dramatically. Fund performance reflected this. And last year's pariahs, like Rogers, have been this year's heroes: Ariel is up 51.6% for the year to date in 2009.
We did a deep dive to quantify the impact of various factors on fund performance in the recent bear market and subsequent rebound. We found a clear pattern. Then we looked to see if this had any correlation with long-term success to determine what it all means to investors.
How We Ran the Study
We took the 235 domestic-equity funds in the Morningstar 500 and looked at the quality and valuation of their underlying holdings to see what impact this had on performance in 2008's downdraft and then in this year's rebound. We used six factors: debt/capital ratio, Morningstar Financial Health Score, free cash-flow yield, the percentage of firms making a profit, Morningstar Profitability Score, and price/earnings ratio. The first two measure debt and liquidity; the next three represent operational strength and profitability; the last shows how cheap a portfolio is.
We ranked funds in quintiles for each factor, analyzed each independently, and then created an overall score for each fund based on the sum of all six factors. We looked at mid-2008 portfolios to capture each fund's profile just prior to that year's biggest swoon. We also looked at early 2009 portfolios to see how the same funds were positioned going into this year's rebound. Then we cross-referenced these fundamental factors with the same fund's performance in 2008 and for the year to date through Sept. 22, 2009.
To see the table, click here.
What We Found
Funds in the Morningstar 500 hardly ever changed their portfolio style, and they landed in one of three broad groups: high quality and low debt, high quality but high debt, and low quality. There was tremendous consistency between the quintile scores from mid-2008 and early 2009. Funds that favored quality in the past continued to do so, while those that dabble in junk didn't change their stripes.
High Quality, Low Debt
The first group of funds has consistently owned high-quality, reasonably priced portfolios full of profitable companies. They held up better than all others in 2008's downdraft but haven't kept pace so far in 2009's rally. Vanguard Dividend Growth