Don’t Play in The Street
Every year, Morningstar’s analysts speak with our portfolio managers, dissect our mutual funds and provide write-ups for their clients, so that the end client can better understand the investment. A good idea…in theory! This past year, Morningstar commented that a number of our portfolios were not as “high quality” as in the past because their financial leverage, as measured by the average debt-to-capital ratio, was well above their benchmark average. Before I continue, let me explain a few things:
- We don’t manage our portfolios to mimic any particular benchmark. Currently, having a higher average debt-to-capital ratio than the benchmark is simply a by-product of our fundamental-based, bottom-up investment process.
- Financial leverage is the process of borrowing capital to make an investment, with the expectation that the profits made from the investment will be greater than the interest on the debt.
- The debt-to-capital ratio is a measurement of a company’s financial leverage, calculated as the company’s debt divided by its total capital. The debt includes all short-term and long-term obligations. The capital includes the company’s debt and shareholders’ equity, which includes common stock, preferred stock, minority interest and net debt.
- For a mutual fund, Morningstar calculates the debt-to-capital ratio as the weighted average of all the portfolio companies’ debt-to-capital ratios.
- One of the by-products of the last recession was that a large number of companies took advantage of historically low interest rates by issuing new debt and/or refinancing existing debt. Generally, what resulted were debt with lower interest rates, extended maturity dates and greater debt amounts on the books.
In our opinion, using merely a debt-to-capital ratio to determine “quality” can be problematic. As you can see from the definition above, the ratio pays no attention to the structure of the debt. Debt structure provides a historical window into a company’s liabilities; it indicates to investors the maturity dates, how soon the business must settle debts and whether it has the money to do so. In fact, despite generally higher corporate debt levels across the board, credit metrics such as debt-service-coverage and debt -to-cash-flow have generally improved.
Much of our evaluation of a company rests on our view of its management. Assuming our view of management is high, the company is sticking to its stated leverage target, the leverage is earmarked to increase shareholders wealth (via share repurchase, special dividend, acquisition, etc.) and the company can continue to finance its balance sheet; we generally accept leverage as a part of doing business.
Of course, not all leverage is created equal. As alluded to above, we spend numerous hours visiting with management teams and studying companies’ balance sheets to determine if current leverage levels or adding additional leverage is suitable for the company. We appreciate the work Morningstar does and the longevity of their brand, but not all quality factors lend themselves well to simple formulas.
All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.