Risk equals return. It's one of the most widely-held maxims in
investing and, if you look at the numbers, the sentiment rings
true. Stocks have returned about 9.5% a year since 1926, according
to Ibbotson & Associates, clearly better than the roughly 5.5%
return bonds have delivered annually during that time. And bonds
have surely beaten cash, which returns nothing.
Even within one
asset class
such as stocks, the maxim holds true -- the riskier the stock, the
higher the potential return. That's surely the case if you look at
the Fidelity Advisor Leveraged Company Stock Fund (Nasdaq:
FLSAX
), the top-performing
mutual fund
in the diversified U.S. category in the past 10 years according to
Morningstar, returning an annual average of 15%. The fund's secret:
embrace companies with plenty of debt, as their inherent riskiness
leads many investors to shun them. Ascash flow builds at these
debt-laden firms, these companies can pay off debt, attracting
investors that had shunned them previously and sending share prices
higher.
Piggybacking with the pros
Fidelity's Tom Saviero has been running this fund since 2003, and
though he's a bit chastened by the 2008 meltdown, he still prefers
companies with ample debt loads.
ON Semiconductor (Nasdaq:
ONNN
)
, which is the fund's largest holding, is a perfect example. The
company just completed a majoracquisition of Sanyo's Japanese
semiconductor business by adding to its
debt load
. But the
acquisition
should sharply boost sales and profits for ON.
ON makes an incredibly wide range of chips that go into everything
from mobile computing devices to cars. This is a semiconductor play
on the broadening advances in technology, not just on one industry
such as memory or microprocessors. Sanyo, which operated three
major fabrication plants in Japan, could never really achieve
profits in the industry and wanted out. ON, eyeing the large
Japanese market, wanted in. ON's management realized it could
acquire all of the legacy products, shutter a great deal of Sanyo's
manufacturing capacity, and ultimately generate much better margins
than Sanyo could. As analysts at DA Davidson note, "leveraging its
scale, one of ON's competitive advantages has been the ability to
successfully integrate strategic acquisitions of complementary
semiconductor suppliers."
The Sanyo deal represents ON's 10th acquisition in the past 10
years, and is the second-largest, at $480 million, behind a $900
million purchase of AMIS Holdings in 2007. Much of the Sanyo deal
is being paid for with a loan from Sanyo -- just the kind of debt
leverage that the Fidelity Advisor Leveraged Company Stock Fund
likes to see.
Analysts expect big things from the Sanyo deal, which could
increase sales by 50%. Sanyo had operating margins below 2%, but ON
thinks it can boost that figure to 10% in four to six quarters. If
that happens, analysts think
EPS
(
earnings
per share) will jump from $1 this year to $1.30 in 2012. DA
Davidson seesshares rising from $9.30 to $17, or 14 times their
2012profit forecast. Needham thinks a multiple of 10 is more
appropriate, and sees
shares
rising more modestly to $13.
A word of caution: The Japanese earthquake will hurt first quarter
results, as ON has already discussed with analysts. But if the
problems extend into the current quarter, then shares may stay
range-bound until the acquired Sanyo operations are fully off the
ground. This may explain why shares have slumped 20% in the past
two months.
Housing would be a kicker
Operations at
Owens-Corning (NYSE:
OC
)
, another key holding of the Fidelity fund, are already humming
along right now, and with an eventual upturn in the housing market,
this stock could really get going. About 2% of the fund is tied up
in this company. Saviero likely appreciated this name for
itsbalance sheet , which still carries more than $1.6 billion in
debt, and because Owens Corning has become a
profit
machine, mostly on the back of its composites and roofing
businesses. (Composites are any combination of materials that are
joined together and are usually used to reinforce objects such as
bathtubs or wind turbines.)
Owens Corning is the leading player in glass fiber composites
(basically adulterated sand) that is a far cheaperoption than
exotic composites such as carbon fiber. The company has generated a
cumulative $470 million in
free cash flow
(
FCF
) in the past two years, and analysts at Citigroup expect to see
another $1 billion in FCF in the next three years.
Owens Corning is also a key player in roofing materials and demand
has held up fairly well, as existing homes eventually need new
roofing tiles. When the housing market rebounds, demand for roofing
materials should spike even higher. So should demand for Owens
Corning's insulation materials. That division is operating at a
small loss right now, but should become quite profitable when new
housing construction trends turn back up.
Add it all up, and analysts at Citigroup see a great profit story.
Per-share profits are expected to steadily rise from $1.57 in 2010
to $3.65 by 2013. All that
cash flow
? Well, it may not be used to pay down debt. Owens Corning likes to
deploy debt leverage, which is fine with Fidelity's Saviero.
Instead, Owens Corning may embark on a major stock buyback program,
according to Citgroup's Josh Levin. He sees shares rising from $37
to $47 over the next year, or 8.7 times his projected 2011 EBITDA
(earnings before interest, taxes,
depreciation
and
amortization
) estimate. Presumably, as he eventually sets his sights on 2012
and 2013 EBITDA projections, his target price will rise in tandem.
Action to Take -->
Fidelity's Saviero has to update his holdings every quarter. It
pays to see which stocks he has recently started buying, or which
stocks he is adding to existing positions. As long as theeconomy
remains aloft, his stock-picking prowess should continue toyield
outsized returns.
As you might imagine, Saviero's is not a "rain or shine" approach.
This kind of investing can be disastrous if the
economy
hits the skids and debt loads get really scary. The fund fell 54%
in 2008. Yikes! Then again, even with that plunge, $10,000 invested
in 2000 would be worth more than $40,000 today.
The fund's future performance is strictly a function of the
economy. If you've got a dim view of the economy for the quarters
and years ahead, then this fund is not for you. But if employment
trends continue and
GDP
(gross domestic product) can climb nicely higher in coming years,
this fund looks poised to continue outperforming many of its peers.
An even savvier approach might be to glean individual picks that
stand out, such as those I mentioned above. Based on Saviero's past
performance, they could turn out to be real winners.
-- David Sterman
P.S. -- Few investors realize that a 20-year energy agreement
between the United States and Russia is about to expire. This deal
supplies 10% of America's electricity. As broke as our government
is, the situation is so serious that President Obama is asking for
$36 billion to avert this crisis. And Republicans support him.
Here's what's going on…
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.