What Makes Fidelity Tick?

A version of this article appeared in the January 2007 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 American Funds and Vanguard Funds are also available.

It's not easy to talk about culture. Describing the culture of nations can devolve into dangerous stereotyping. Describing the culture of organizations often lapses into platitudes like "a dynamic company with first-rate human capital." Very helpful.

So why even attempt to outline the cultural attributes of a mutual fund company as protean as Fidelity Investments? The answer is that Fidelity, like any asset manager, has a unique history that has shaped the way it runs money and conducts its business. Understanding Fidelity's culture can give fund shareholders a prism through which to view their funds' behavior. After all, if you're entrusting your nest egg to a mutual fund company, it pays to "Know what you own and why you own it," in the words of the old Peter Lynch commercial.

Here, I'll lay out what I see to be the three key planks of Fidelity's culture and what each means for you, the Fidelity investor. My impressions have been shaped by my research for the Fidelity Fund Family Report, the collective experience of my Morningstar colleagues, and several books, including Fidelity's World, by Diana Henriques; A Piece of the Action, by Joseph Nocera; The Money Game, by Adam Smith; and One Up on Wall Street, by Peter Lynch.

1. "Two Men Can't Play the Violin"
Edward Crosby Johnson II, who founded Fidelity Investments in 1946, was something of a rebel. Johnson thoroughly rejected the conservative investment culture from which he emerged--that of the Boston trustee. Fidelity would be vastly different from other blue-blooded firms. It took risks. And it did not manage money by committee. "Two men can't play the violin," Johnson often said. He dedicated himself to hiring and training artists whose canvases were mutual funds.

The concept of a star portfolio manager is a Fidelity creation. The first was Gerry Tsai, who ran Fidelity Capital in the late '50s and early '60s. The second was Johnson's son, Edward C. "Ned" Johnson III, who cut his teeth on  Fidelity Trend (FTRNX) and who has been Fidelity's chairman since 1972. Current stars Joel Tillinghast ( Low-Priced Stock (FLPSX)) and Will Danoff ( Contrafund (FCNTX)) join a pantheon that includes Dorsey Gardner, Leo Dworsky, Bruce Johnstone, George Vanderheiden, Neal Miller, and the most famous of them all, Peter Lynch.

Because "Mister Johnson," as the founder was known, viewed investing as more art than science, he did not impose a uniform approach on managers. Success at Fidelity has always been more about individual talent than institutionalized process. Johnson's own investing was shaped by his interest in psychology. Although Tsai knew Corporate America backward and forward, he incorporated "technical" criteria, such as a stock's price momentum and trading volume--indicators that Fidelity tracks to this day. Lynch, who remains a role model to many Fidelity managers, said he looked for six categories of stocks: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. Translation: He bought any stock he thought would go up.

Mister Johnson created an atmosphere of intellectual vivacity that survives till this day. Recruiting has always been a top priority for Fidelity, and eccentricity has long been tolerated, as long as it comes with talent. New analysts have traditionally earned their stripes by contributing ideas to portfolio managers. They have also learned by doing, running small funds in order to find their style through trial and error.

Implications: It's no exaggeration to say that Fidelity houses some of the biggest brains in the asset-management business. Joel Tillinghast can give a detailed analysis of Holding No. 731 in his Low-Priced Stock portfolio. Portfolio managers are supported by abundant resources and aren't burdened by much marketing. But because portfolio management has long been the be-all and end-all, Fidelity's domestic-equity research effort has fallen behind. Stock analysts rotating across sectors in preparation for running diversified funds can't develop deep industry knowledge. And they don't have to be trusted with your money.

In the interest of not constraining talent, Fidelity funds have traditionally had flexible mandates that give their managers lots of latitude.  Fidelity Growth & Income (FGRIX) has owned tiny biotech stocks, and  Fidelity OTC  (FOCPX) once owned blue chips. With some exceptions, notably the bond-fund lineup, you choose Fidelity funds by their manager. Think of today's  Fidelity Magellan (FMAGX) as "Fidelity Harry Lange," because Lange runs Magellan very differently than did his predecessor. Manager change forces you to re-evaluate your reasons for owning a fund. Not all managers are geniuses, and the portfolio turnover that changes trigger can cause tax headaches. Manager change is common at Fidelity for three main reasons: the intensity of the job, talent poaching, and the practice of plucking promising managers to run larger funds. Talent, in Fidelity's view, deserves the biggest possible stage.

2. Fidelity is No Fuddy-Duddy
Value investing, which traces its origins to Ben Graham, is rooted in a cautious, skeptical world view. Graham and his intellectual progeny, most notably Warren Buffet, abhor losing money and shun the popular issues of the day. Theirs is a contrarian approach that requires immense fortitude and legendary patience. Value investors are at their most ecstatic when the market is down. During good times, they "bah humbug" from the sidelines.

Caution, skepticism, and patience have never been the Fidelity way. Just as Mister Johnson rebelled against the committees of the Boston trustees, he also rejected their preoccupation with avoiding losses. As Peter Lynch would write, "Mister Johnson believed that you invest in stocks not to preserve capital, but to make money. Then you take your profits and invest in more stocks, and make even more money."

Mister Johnson had an optimistic outlook that emphasized being in tune--both with the modern world and with the modern market. "When the music stops, forget the old music," he told Adam Smith. As the name of his second fund, Fidelity Trend, would imply, he was not a man who pooh-poohed the latest fads. That his son Ned ran Fidelity Trend should not be overlooked, nor should the fact that Ned's daughter Abby ran the fund in the mid-1990s.

Fidelity funds have participated in almost every major market trend of the past six decades. In the post-World War II years, Johnson bought fledgling companies such as Paramount Pictures. In the 1950s it was IBM, Polaroid, and Coca-Cola. No one rode the electronics boom of the 1960s harder than Tsai at Fidelity Capital. And the bull market of the 1980s belonged to Lynch, whose winners--Dunkin Donuts, Toys 'R' Us, and Charles Schwab--showed his finger to be firmly on the pulse of the American middle class. Neal Miller at  New Millennium (FMILX) was talking about networking stocks like  Cisco Systems  (CSCO) before the Internet set the market on fire in the 1990s. And since 2000, Fidelity has played the development of alternative energy sources along with high-fliers  Apple (AAPL) and  Google (GOOG).

In its search for the blue chips of tomorrow, Fidelity does not, like Buffett, throw whole categories of stocks into the "too hard to understand bucket." Nor do most Fidelity managers share Buffett's view that good ideas are hard to come by. Lynch once held 1,400 stocks in Magellan, including 150 savings and loans. Lynch, like most Fidelity managers, cared about price but would pay up for growth potential. Where he saw a rising tide, he bought all the boats.

Yet another point of difference between Fidelity and the value-investing crowd is in time horizon. Fidelity managers tend to think of themselves as buyers and sellers of stocks, as opposed to owners of businesses. Unlike Buffett, their ideal holding period is not "forever." "Stocks you trade, it's wives you're stuck with," as Lynch quoted Mister Johnson saying. Many Fidelity managers consider 18 months to be a long time.

Fidelity's ability to read prevailing winds has extended to its business side. Combine a lack of skepticism toward trends with Ned Johnson's tremendous business acumen with the fact that Fidelity, as a private company, can take a long-term view, and you get an organization often at the forefront of its industry. Ned Johnson started the money market fund revolution during the 1970s' bear market, then followed Vanguard down the direct-to-consumer sales route by eliminating loads. Johnson was also quick to spot the potential of the IRA and later 401(k) as sales channels.

Fidelity's lineup went from two dozen in the 1970s to 100 in the 1980s to 200 in the 1990s to more than 300 today. In the inflationary environment of the late 1970s, Fidelity launched a gold fund. In the 1980s, it rolled out the first junk-bond fund and then reintroduced the American investor to the sector fund. In the 1990s, it brought out a slew of foreign-equity funds and every stripe of fixed-income offering. For those who want asset allocation, Fidelity created the Asset Manager funds and for those who want retirement planning, the Freedom Funds. To Fidelity's credit, though, it did not roll out an Internet fund, although  Select Networking & Infrastructure  had the unfortunate inception date of September 2000.

Implications: You can expect most Fidelity funds to more than participate in growth-led markets. But when the market crashes, as it did in 1968, 1987, and 2002, Fidelity funds can suffer badly. And when value stocks lead the market, as they have since 2000, Fidelity also suffers. Because of Fidelity's traditional growth orientation, this is not the best place to go for a classic value fund. Moreover, the short-term game that Fidelity plays has become harder to win in recent years. Fidelity's access to Corporate America is no longer the advantage it once was. And because short-termism can involve lots of trading, Fidelity isn't much for tax efficiency. Meanwhile, Fidelity's asset-gathering skills can cause funds to get too big. As far as the vast lineup goes, remember that you don't have to latch on to every market trend to make money. The best strategy is to buy broad funds with managers who can use their flexible mandate opportunistically.

3. Kaizen
Ned Johnson is a big believer in the Japanese concept of "kaizen," striving for perfection through ongoing improvement. Fidelity has always sought to be the best; in fact, the shop is credited for pioneering the "performance fund" concept in the 1960s. The goal was not just to make money, but to beat that market, and, crucially, the competition. Some have theorized that Fidelity's expense ratios are low in order to give its funds a leg up over the competition. Performance fees, whereby the management fee goes up if a fund beats its benchmark and down if it doesn't--are very much in keeping with Fidelity's competitive streak.

Kaizen has driven Ned Johnson's desire to conquer new distributional channels and fund categories. Kaizen is also responsible for much organizational change, even when it has meant killing sacred cows. Fidelity has let two men play the violin (both  Fidelity Mid-Cap Stock  (FMCSX) and  Fidelity Blue Chip Growth (FBGRX) had two managers for a time) and has rolled out index funds (Where's the art in passive management?). After undermining brokers by selling direct to investors, Fidelity doubled back and launched an advisor-sold fund lineup. Turnover in the executive ranks ensures fresh perspectives. In January 2007, fund chief Steve Jonas retired after less than two years on the job.

Kaizen also means that problems are not left to fester for long. When errant interest-rate bets and ill-conceived forays into Mexican debt got its bond funds into trouble in the mid-1990s, Fidelity turned its fixed-income operation into one of the best and most predictable in the business. When a number of funds, most notably Jeff Vinik's Magellan, got caught holding too much cash in the mid-1990s bull market, Fidelity's then fund chief, Bob Pozen, instituted controls. With Fidelity so prominent on 401(k) platforms, funds needed to provide more predictable exposure to designated asset classes. So managers no longer shift assets into cash, and benchmark sensitivity has increased.

Implications: Commitment to kaizen is largely a positive for Fidelity shareholders. Over the past two years, we've seen Fidelity undertake a massive expansion and reorganization of its domestic-equity lineup designed to restore its edge. Hiring experienced analysts and allowing them to make a career of research--both firsts for Fidelity--are encouraging steps. So is Fidelity's decision to base manager compensation on longer-term returns. Kaizen has pushed Fidelity to develop state-of-the-art technology, drive down trading costs, and to deal forcefully with improprieties. Kaizen even led Fidelity to close six funds in 2006--an apparent acknowledgement that asset bloat threatens performance.

Conclusion
True, the days when Fidelity reigned over the American mutual fund industry are long gone. The shop now sits behind American Funds and Vanguard in terms of assets under management. Through a combination of Fidelity slipping and competitors catching up, a playing field that Fidelity once dominated has been leveled. And yet, I wouldn't count Fidelity out. If growth investing comes back into market favor, Fidelity funds will start to look a lot better. And I'm cautiously optimistic about changes the shop has taken. Especially if you're looking for fixed income or international equity, Fidelity has a lot to offer. And there are still gems on the domestic-equity side, too. It is crucial, however, to pick the right manager and to be wary of bloated funds. Check my list of favorites in the Fidelity Fund Family Report.