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Fund Spy

When Debt Was Poison

Debt played a leading role determining 2008's losers and this year's winners.

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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 (ARGFX) losing 48.3%.

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.

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