What's Fueling Fidelity's Rebound?

Christopher Davis is editor of Morningstar's Fidelity Fund Family Report, a monthly newsletter that offers independent guidance on the fund family and helps investors find the best Fidelity funds. 

It's been a while since I've cracked open a physics textbook, but I somehow haven't forgotten Isaac Newton's three laws of motion. I sometimes wonder if Newton's third law--for every action, there's an equal and opposite reaction--governs the financial markets, too. For example, the stocks that suffered the most severe losses in last year's bear market were generally among the biggest winners in the recent rally.

With a heavy helping of many of 2008's worst performers, most of Fidelity's equity funds had an especially rough go of it last year. But as last year's losers have gone from Brunhilda to belle of the ball more recently, so have Fidelity's funds. Through June, 126 of 181, or nearly 70%, of domestic Fidelity funds beat their category averages. That's a total role reversal from 2008, when about 70% of the funds lagged the competition. (Fidelity's international funds have generally avoided such extremes; just under half lagged their category rivals in 2008, while just over half have outpaced them for the year to date.)

Fidelity failed in 2008 simply because too many of its funds were taking on too much risk. If the funds got themselves in trouble by taking outsized risks, it's fair to ask whether they are unburying themselves by doing the same thing. One way too gauge risk is to see whether the funds are investing in companies with competitive advantages and relatively predictable businesses.

Risk, Moats, and Fair Value: A Quick Primer
In 2008, backward-looking traditional risk metrics, such as standard deviation, often had little value in explaining performance. But other measures did a much better job. My colleague David Kathman looked at large-cap funds' average moat ratings at the end of 2007 and found those with the highest average moat ratings far outpaced those with the lowest moat ratings in 2008. David also examined funds' average fair-value uncertainty ratings and discovered a similar pattern. The more uncertain the fair value of its holdings, the weaker the returns. No wonder most Fidelity funds fared poorly in 2008: Relative to their competition, Fidelity managers disproportionately favored smaller moat, higher-uncertainty stocks.

David drew upon Morningstar's equity research to come to his conclusions. Morningstar's 100-person plus team of stock analysts track nearly 2,000 stocks, in each case assigning a moat rating (wide, narrow, none) based on their analysis of the company's competitive advantages and a fair value derived from an estimate of its future cash flows. Fair-value uncertainty ratings (which range from low to extreme) stem from the analysts' confidence in that value based on a range of possible scenarios. Wide-moat companies boast especially strong competitive advantages, while those with low fair-value uncertainty ratings usually have stable businesses and predictable cash flows. Because investors prize stability and survival in downturns, stocks of companies with wide moats and low fair-value uncertainty tend to outperform in bear markets. That's what happened in 2008.

A Junk-Fueled Rally?
Investors have become more optimistic lately as some signs have emerged indicating the economy has come back from the brink. Again, moats and fair-value uncertainty have been useful measures to explain performance in the recent rally. Less worried about the survival of iffy companies, investors bid up shares of no-moat, high-uncertainty stocks most of all. While the rebound has been wide-reaching--the broad Wilshire 5000 Index rose 16% in the second quarter--no-moat stocks surged 108% in the second quarter, versus just 16% for wide-moat stocks. Similarly, stocks with extreme fair-value uncertainty ratings soared a remarkable 127%, compared with 13% for low-uncertainty stocks.

Not surprisingly, the extent to which Fidelity managers invest in stocks with moats had a meaningful impact on performance in the second quarter. I ranked Fidelity's 80 diversified domestic-equity funds by quartile according to their average moat rating. On average, funds with top-quartile average moat ratings finished in their category's 57th percentile, while those in the bottom quartile landed in the top 20%. Similarly, funds with bottom-quartile fair-value uncertainty ratings placed around their category's 60th percentile on average, but those in the highest two quartiles landed in the top third.

True, most Fidelity funds had beefed up their exposure to stocks with moats by the end of 2008. But as of April 2009 (the most recent portfolio data available), just 16 of 80 diversified domestic-equity funds had average moat ratings higher than the broad market's (and four are index funds). It's not as surprising that all of Fidelity's mid- and small-cap funds have below-average ratings (smaller companies often have weaker competitive advantages), but most of the firm's large-cap funds (37 of 53) fall in this camp, too.