What’s the case for including leveraged company stocks in portfolios?
There's about 600 high yield companies with publicly traded stock. Their combined market cap is over three trillion dollars and they're mostly in the small and mid cap range. I think there's three reasons why these types of stock can make an attractive investment opportunity. First, the stocks of leveraged companies have historically out performed the market. This is surprising to a lot of people, but it's really just basic financial theory. The more risk you take, the higher your expected return. This is why high yield bonds are expected to out perform investment grade bonds and historically, they have because there's more risk. The second reason is portfolio diversification. Equity mutual funds systematically under invest in leverage company stocks and this is something I call the strong balance sheet bias. This is unfortunate because, as I mentioned, leveraged company stocks have historically out performed the market. Third there's a unique opportunity here to generate alpha. These stocks are overlooked and misunderstood by many equity investors because of their small market caps, their complex capital structures and let's face it, there considered junk by a lot of investors because of their high yield credit rating. So there is an opportunity to exploit this market inefficiency by an investor who understands capital structures, and the risk reward profiles of these types of stocks. so these stocks probably shouldn't be a core allocation for a lot of investors, but there's a compelling argument to be made as a compliment to existing core allocations because they've out-performed historically, they provide the diversification and there's an opportunity to generate alpha.
Views are as of 3/15/2018 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Securities issued by leveraged companies, including securities of companies that issue below investment grade debt or “junk bonds”, may be more volatile, be more sensitive to adverse issuer, political, market or economic developments and have limited access to additional capital than securities of other, higher quality companies or the market as a whole, which can limit their opportunities and ability to weather challenging business environments. Federated Investment Management Company 18-73703 (3/18)