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Is Fidelity Magellan Sailing in the Right Direction?

The fund's long-suffering investors should give the new skipper a chance.

A version of this article appeared in the June 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.

It's been a while since Fidelity Magellan (FMAGX) dominated the American mutual fund landscape. As Peter Lynch and his brilliant record fade into history, Magellan's place has been usurped by Bill Miller's Legg Mason Value (LMVTX), Bill Gross' PIMCO Total Return , and the gargantuan American Funds Growth Fund of America (AGTHX). Magellan isn't even the largest ship in Fidelity's fleet anymore. Last year, Fidelity Contrafund (FCNTX) surpassed it in asset size.

But old memories die hard. The perception remains that as Magellan goes, so goes Fidelity, which is why the fund's underperformance from 2000 to 2005 tarnished the company's image and helped spur significant organizational change. Plus, any fund with $50 billion in assets can't be ignored.

Magellan has now spent more than eight months under its new manager, Harry Lange. Although I think there are better core fund options (in any case, Magellan remains closed to most new accounts), I like the direction in which Lange is steering the fund. In fact, I think the Magellan investors who are withdrawing money now are making a mistake. The fund is better poised for success now than at any point in the past decade.

Magellan's New Skipper
When the powers that be at Fidelity tapped Harry Lange to take the helm at Magellan on Oct. 31, 2005, they knew it would be charting a new course. Anyone familiar with Lange from his decade-long stint on Fidelity Capital Appreciation (FDCAX) knows him to be an aggressive, growth-oriented investor. That's a contrast to his predecessor, Bob Stansky, whose conservative style yielded subpar returns over his nine-year tenure.

Lange built a stellar record on Capital Appreciation by paying little heed to indexes. His portfolios typically held lots of smaller stocks (not surprising given that Lange also ran Fidelity Advisor Small Cap (FSCTX)), foreign names (Lange began his career at Fidelity as a research analyst in Tokyo), and technology (Lange ran tech sector funds at Fidelity before getting a diversified portfolio).

An Extreme Makeover
In interviews following his appointment, Lange signaled many of the changes he would make (not to mention signaling his confidence in the strategy by putting more than $1 million into the fund). That said, I was still taken aback when his first portfolio revealed just how profoundly Magellan had changed. The number of holdings hadn't grown as much as Lange had predicted (from 200 under Stansky to 276 as of March 31, 2006), but Magellan had taken on a bolder, racier feel in every respect.

Lange dumped most of the S&P 500 stalwarts that Stansky favored--names such as Intel (INTC), Pfizer (PFE), Time Warner , and Bank of America (BAC) (causing capital gains pain for the minority of Magellan investors in taxable accounts)--and redeployed those assets to growthier large caps such as Seagate Technology (STX) and Google (GOOG), mid-caps such as Whole Foods Market  , and lots of foreign names. As of March 31, 2006, Lange was devoting 26% of the portfolio's assets to foreign equities. Some are playing prominent roles. Nokia (NOK), Nomura Holdings (NMR), and Yahoo Japan have at times cracked the top 10.

Lange has explained that Magellan's size hasn't kept him from owning the stocks he wanted to own, and he hadn't had to increase the number of portfolio holdings to spread assets around. He has acknowledged that outflows have made Magellan somewhat easier to maneuver. Since topping out at more than $105 billion in assets in 1999, the fund has been steadily losing investors. There's nothing small and nimble about the $47 billion asset base Lange was managing as of June 1, 2006, but he's not restricted to the market's biggest and most liquid stocks the way Stansky was in his early years.

Some contrarians would argue that Lange is giving up on blue chips at exactly the wrong time--just as they are poised to take over market leadership from cyclicals and smaller fare. But while he acknowledges that smaller caps have had a phenomenal run, Lange has argued that it's a mistake to assume that the same names that dominated the last large-cap rally will rule the roost this time around. This reminded me of a section in One Up on Wall Street, when Lange's forerunner, Peter Lynch, cited a succession of stocks once viewed as suitable for "widows and orphans" that have faded from the scene. Clearly, Lange sees a stock such as Pfizer (PFE) as yesterday's name, akin to Lynch's examples of RCA, Bethlehem Steel, DuPont, and General Motors (GM).

As for the foreign stake, Lange is merely restoring Magellan to its roots, when, as its name would imply, it was a globe-trotting fund. Lange bought a group of Japanese banks, real-estate-oriented companies, and trading houses, not to mention Yamada Denki, frequently referred to as the Best Buy of Japan. A longtime Japan watcher, Lange sees real signs of life in that long moribund economy.

The Results So Far
Everyone, especially long-suffering shareholders, is eager for signs of improvement at Magellan. That explains the excitement expressed at the end of 2005, when, due to Lange's changes, the fund beat the S&P for the first calendar year since 1999.

That also explains the dismay expressed lately. Everything that worked for Magellan in the fourth quarter of 2005 and the first quarter of 2006 started backfiring in May 2006. Technology and Japan are the two biggest reasons Magellan has fallen far behind both its bogy and its peers.

The Upshot
Magellan's wild ride under Lange is a good indication of the volatility that his approach invites. And while volatility can be unsettling, I'd urge investors not to make too much of short-term performance swings. I wouldn't read much into Magellan's performance over a month, a quarter, or even a year. This is no longer a fund that moves in lockstep with the S&P 500. But that's a good thing because Magellan investors are paying for active management.

If Magellan were a smaller, nimbler fund, I would recommend it heartily. Capital Appreciation was a Morningstar Fund Analyst Pick and hands down one of our favorite growth funds. Although a bold growth investor, Lange also has a history of counterpunching, especially in the tech sector. When tech stocks are down, he has been a buyer and when prices have run up, he's been a seller. My guess is that he'll maneuver through these choppy waters in similar fashion. I see his talents as reason for Magellan investors to think twice about jumping ship.

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