Top stock picker excels by investing in risky debt

Thomas Soviero has unseated Ken Heebner as manager of the best-performing diversified U.S. stock fund over the past 10 years. His secret: companies with poor credit. Mr. Soviero's $4.2 billion Fidelity Advisor Leveraged Company Stock Fund Ticker:(FLSAX) averaged 15% annual returns through March 31, best among 3,617 peers tracked by Morningstar Inc. Mr. Heebner, whose CGM Focus Fund Ticker:(CGMFX) held the top position for the previous 11 quarters, slipped to ninth place with a return of 14%. Junk bonds climbed 8.4% a year in the span. “Debt doesn't have to be a four-letter word,” said Mr. Soviero, whose fund buys stocks of companies with speculative-grade debt. “When it works in your favor, good things can happen.” The 47-year-old is betting on more gains after a rally in junk bonds allowed companies to reduce borrowing costs, disagreeing with value investors such as Jeremy Grantham who contend that debt-laden companies may underperform as the economic rebound loses steam. Mr. Soviero took over in mid-2003 and helped guide Leveraged Company Stock Fund to a record 92% surge that year. It lost a record 54% in 2008 when he underestimated the global economic crisis. When the economy levels off, bigger companies with stronger balance sheets often can increase earnings faster than weaker rivals, said David Joy, chief market strategist at Columbia Management Investment Advisers LLC.

BIGGER COMPANIES

“Typically, at this point in the cycle, you want to migrate towards bigger, higher-quality companies,” said Mr. Joy, who oversees $350 billion. Mr. Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co. LLC, and Donald Yacktman, president of Yacktman Asset Management Co., said that large companies with stable returns and low debt are the best place to put money now. “U.S. quality stocks are the least-overpriced equities,” Mr. Grantham wrote in a January newsletter. Like junk bonds, the stocks Mr. Soviero owns fared best when interest rates were low, the economy was improving and companies had easy access to credit. As companies paid down debt and refinanced at lower rates, they increased cash flow and attracted equity investors. “The trade in these stocks has worked for years,” said Margaret Patel, who manages more than $1 billion in junk bonds and stocks for Wells Fargo & Co. Ms. Patel said the “virtuous circle” that has supported stocks of indebted firms will continue unless interest rates soar or the economy slides back into recession.

HIGH-YIELD MANAGERS

The idea for a leveraged-stock fund came from managers in Fidelity's high-yield-bond department, who noticed in the late 1990s that the equities of companies in which they invested often outperformed the junk bonds. Bond returns are limited by changes in interest rates and credit spreads, Mr. Soviero said, while “stocks can rise as much as the market drives them.” The Fidelity Advisor Leveraged Company Stock Fund was created in December 2000. Mr. Soviero, who earned a bachelor's degree in finance from Boston College, joined Fidelity Investments in 1989 as a research analyst. He later worked on several high-yield-bond funds before replacing David Glancy, the fund's original manager, who left the firm. “High-yield research is one of Fidelity's unsung strengths,” said James Lowell, editor of the independent Fidelity Investor newsletter.