Our Highest-Conviction Fidelity Fund

A version of this article appeared in the May 2006 issue of Morningstar's Fidelity Fund Family Report, our monthly newsletter dedicated to helping Fidelity investors find superior long-term investment opportunities. To review a risk-free trial issue of our Fidelity Fund Family Report, click here. Fund Family Reports on Vanguard and American Funds are also available.

Readers of Morningstar's stock and fund analysis know that we advocate a contrarian approach to investing. It's our belief that a successful investor is one who heeds Warren Buffett's maxim: "Be fearful when others are greedy and greedy when others are fearful." That means loading up on what's down and running in the opposite direction from what's hot.

Recent market turmoil presents a classic opportunity to be contrarian. For this reason, I reran a study I conducted recently for our Fund Family Report on Fidelity, identifying the best contrarian picks at the shop. Specifically, I trawled Fidelity's lineup to identify the fund with the largest share of undervalued stocks in its portfolio.

The Stars Align
To conduct this search, I enlisted the help of my 90 equity analyst colleagues who assign Morningstar Ratings to some 1,800 stocks. Unlike the mutual fund star rating, a quantitative metric that compares a fund's risk-adjusted returns to a peer group, the star rating for stocks is subjective and forward looking. Equity analysts assign "fair values" to stocks by assessing a company's ability to sustain its competitive advantage and maintain, or increase, cash flows over time.

When a stock price falls to a deep-enough discount to our analyst's estimate of the company's fair value, the stock will be rated 4 or 5 stars. Conversely, a 1- or 2-star stock is one that is trading at a significant premium to our analysts' estimate of its fair value. A 3-star stock is fairly valued. I should note that my equity analyst colleagues have racked up impressive results applying the Morningstar Rating for stocks in the real-life portfolios in Morningstar StockInvestor. And, due to a recent sell-off, a huge number of stocks now sport 4- and 5-star ratings.

Narrowing the Sights
For the purpose of this exercise, I focused exclusively on Fidelity's domestic large-cap equity funds.

Not only is that where Morningstar's equity coverage is largely centered, it's also the most contrarian hunting ground. Small- and mid-cap stocks have been beating the pants off their larger cousins for several years now. While I'm a big believer in foreign equity exposure, overseas markets, especially those of emerging economies, have been hot. And alternative asset classes like gold and real estate have been even hotter. The biggest mistake an investor can make is to assume that these trends will persist and that large caps will stay down forever. In fact, a recent market correction may have signaled that the tide has already turned.

I looked through the portfolios of the more than 25 no-load Fidelity funds that fall into our large-blend, large-growth, or large-value categories to determine how many 4- and 5-star stocks reside in their portfolios. Most of the funds I looked at had enough stocks under coverage for this exercise to be meaningful, though  Fidelity Contrafund (FCNTX) and  Fidelity Magellan (FMAGX), with more than one quarter of their assets in foreign names, had the smallest percentage of their portfolios under coverage by Morningstar analysts. I should also note that most of our holdings information is from the first quarter of 2006, whereas the star rating is current, so we don't know if the funds are still holding their undervalued securities.

And the Winner Is...
 Fidelity Dividend Growth (FDGFX) has far and away the biggest percentage of undervalued stocks in its most recently available portfolio, based on our analysts' assessment. Roughly half of its holdings are rated 4 or 5 stars. (As a point of reference, roughly 30% of the stocks in the S&P 500 had 4- or 5- star ratings as of June 6, 2006.) The top 10 holdings, which consume the lion's share of the portfolio's assets, are made up almost entirely of stocks trading below our fair value estimates, including  American International Group (AIG),  Microsoft (MSFT),  Wal-Mart Stores (WMT),  Pfizer (PFE), and  Bank of America (BAC).

The fact that so many of this fund's holdings are undervalued reflects a painful fact. This fund has been mired in the large-blend category's bottom quartile for the past three years. Its high-quality mega-cap portfolio has hurt performance relative to funds with lots of exposure to smaller caps and cyclical fare. But manager Charles Mangum has stuck to his strategy. He buys companies with rock-solid balance sheets and stable profit growth that either pay dividends or have the ability to do so. I like the fact that Mangum is patiently waiting for the market to recognize the value of his holdings, rather than trying to catch short-term market trends. That discipline is one of the reasons we made Dividend Growth a  Morningstar Fund Analyst Pick several years ago.

I recently placed the fund on the list our favorite Fidelity funds--a regular feature of the Fund Family Report--because I think it's time is now. Aside from a sound investment approach, I like the fund's expense ratio (just 0.58%), Mangum's experience level (he has been at the helm for nearly 10 years), and the fact that he's eating his own cooking (SEC disclosures reveal that he has committed more than $1 million of his own money to the fund). All the investors who have abandoned Dividend Growth in recent years may soon come to regret their decision. The fund held up well during the market sell-off in May, and I think it has a good chance of going from laggard to leader over the next few years.

Notable Runners Up
To their credit, most of Fidelity's large-cap funds held more undervalued stocks than the S&P 500. After Dividend Growth, the funds with the highest percentage of their holdings trading below our estimates of their fair value were  Fidelity Large Cap Stock (FLCSX) (42%),  Fidelity Growth & Income (FGRIX) (41%),  Fidelity Fifty  (40%), and  Fidelity Equity-Income (FEQIX) (38%).

Of those, I have the highest conviction in Equity-Income. Like Dividend Growth, Equity-Income is run by a patient, long-tenured manager with a sound strategy, Stephen Petersen. I also like Growth & Income, whose new manager, Tim Cohen, is one of Fidelity's rising stars.

That said, both Petersen and Cohen are running large sums of money, which limits their flexibility. Though their focus on mega-caps and low-turnover styles are mitigating factors, Dividend Growth's smaller asset size gives it an edge. For Fidelity investors, now is a classic opportunity to be greedy when others are fearful.