How Well Is Fidelity Steering Through the Crisis?

"Adversity reveals genius, prosperity conceals it," said the ancient Roman poet Horace.

Something tells me he probably wasn't talking about investing--that is, unless the Roman Forum had a stock exchange I don't know about. But he easily could have been. In bull markets, nearly anyone can make money, obscuring who's really talented and who's merely lucky. Downturns, however, put investors' skills to test.

This year has been some test. The U.S. financial system has more or less teetered on the brink thanks to tanking housing prices and the resultant credit crisis. Icons of American finance, ranging from Bear Stearns to Merrill Lynch, have either disappeared altogether or into much-larger organizations. And firms too big to fail-- Fannie Mae (FNM),  Freddie Mac (FRE), and  American International Group (AIG)--nearly did, saved only by the grace of a government bailout.

In this article, I'll look at how well Fidelity funds have navigated the credit crisis and explore what their recent performance says about Fidelity's research capabilities.

Fidelity and Financials: The 360-Degree View
Financials are prime stomping grounds for value funds, so the credit crisis has hit them especially hard. Fidelity's growth-leaning lineup, however, has helped insulate it from financials' fall. Fidelity managers generally look for earnings growth, and you won't find much of that among financials these days. Not surprisingly, most Fidelity funds (though not an overwhelming majority) have less exposure to financials than the competition. Indeed, 59 of 109--or 54%--of diversified domestic and foreign equity funds had below-average financials weightings versus their category peers as of August 2008.

To be sure, Fidelity was shedding its holdings in many troubled financials stocks in the spring and summer. According to Fidelity's most-recent SEC filing of its firmwide holdings, the firm had pared back in its exposure to Lehman Brothers by 20% in 2008's second quarter. (By July, only nine Fidelity funds had more than 0.5% of assets invested in the stock.) It also deserves credit for scaling back on  Morgan Stanley (MS), Merrill Lynch, and  Citigroup (C), which suffered steep losses in the ensuing period.

Even as Fidelity was pulling away from some distressed financials, it was moving toward others.  Goldman Sachs (GS) looks like a survivor, but it's a weakened one and one in which Fidelity added heavily to in the second quarter. Since Goldman will likely remain a going concern, at least there's some potential for rebound. Unfortunately, you can't say the same for AIG, Fannie, Freddie, and Wachovia--all of which Fidelity added to heavily in the second quarter. Its firmwide stake in Fannie grew 20%, for instance, while AIG rose 16%.

Bank stocks with stronger financial positions, such as  J.P. Morgan Chase (JPM) and  Wells Fargo  (WFC) have suffered far smaller losses than weaker competitors. However, Fidelity reduced its holdings in both stocks in the second quarter by 15% and 5%, respectively. In surgical terms, Fidelity only partially removed a cancerous tumor, while cutting into healthier tissue.

Try to Catch a Falling Knife and You Might Get Cut
If your research centers around spotting companies with improving earnings, you might not be quite as good at analyzing depressed firms. I'd be painting Fidelity with too broad a brush to say it hasn't or couldn't be successful investing in deep-value fare. But lately, it has run into trouble. Take  Fidelity Magellan (FMAGX), for example. When I visited Fidelity's Boston headquarters in the spring, manager Harry Lange told me the market wouldn't recover without financials rallying. I suspect he's right. The problem is he started buying just as the credit crisis was gathering steam, and since then it has flattened picks like AIG, Goldman Sachs, and Wachovia. Lange has successfully moved into beaten-down sectors throughout his career--at prior charge  Fidelity Capital Appreciation (FDCAX) he delved into tech in 2002 before its sharp 2003 rebound--but he underestimated the impact the credit crunch would have on his picks.

As poor a year as it has been for Magellan,  Fidelity Growth & Income  (FGRIX) may have been an even bigger disappointment. That offering has been ensnared by many of the same woes as Magellan, with Fannie and Freddie thrown in for good measure. Manager Tim Cohen gravitates toward stocks that are out of favor and began buying financials last year when they started falling. The problem, of course, is that they had much farther to fall. Unfortunately, this continues Cohen's pattern of poorly timed picks. Homebuilder stocks started coming under pressure in 2006, and he thought they were cheap. As the subprime mortgage debacle gathered steam in 2007, the stocks tanked. With a long career of success, it's easier to stand by Lange despite his recent mistakes. Cohen, though, has just had too many misfires to earn my confidence.

Fidelity's focus on earnings growth proved helpful in other instances, especially at  Fidelity Contrafund (FCNTX). Manager Will Danoff looks for stocks with improving prospects, and he won't invest unless there's proof things are getting better. He's famous for asking analysts tough questions, but he also likes to do a lot of legwork himself. A big piece of his research comes from meeting with company managements. When I spoke with Danoff in July, he told me he's gotten nothing but glum outlooks from financial companies, so he was reluctant to dive in. He hasn't gotten everything right this year and he's well into the red--his energy and tech picks have stung--but Contrafund is yet again ahead of the large-growth pack. In fact, as my colleague Arijit Dutta noted in a recent Morningstar Mutual Funds commentary, Contrafund is one of the few funds that's not only beaten its peers in this most-recent bear market, but also in the early 2000s and 1990 slumps as well.

Is Fidelity's Financials Research Up to Snuff?
Managers that dodged the bullet may have done so in spite of Fidelity's financials research, not because of it. One big reason to doubt the firm's capabilities is the bruising 55% loss  Fidelity Select Financial Services (FIDSX) suffered over the trailing 12 months through Nov. 14 (yes, other financials funds are down too, but it's fared much worse than average). Run by Fidelity's lead financials analysts, Richard Manuel and Benjamin Hesse, the fund provides a window into the firm's thinking on the sector and sends a message to diversified portfolio managers where they think the best opportunities lie. If those managers have been paying attention to its returns over the past year, my guess is they might be leery of the analysts' research.

If they are, I can't say I blame them. In the April 2008 Fidelity Fund Family Report, I explained my own doubts, with my chief concern being that Manuel may be too confident in his ability to assess tough-to-buttonhole risks. In Morningstar's 2007 visit to Fidelity, Manuel told a couple of my colleagues that he and former comanager Brian Younger were convinced they could precisely calculate Citigroup's exposure to subprime mortgages--a feat that Citigroup itself couldn't pull off. Since then, he hasn't exactly bolstered my confidence. Even as Fidelity as a whole was paring its exposure to the likes of Lehman Brothers and Morgan Stanley during the summer, Manuel was adding to his positions. In August, he also ramped up his stakes in Fannie Mae and Wachovia--right before the former fell into government conservatorship and the latter plunged and agreed to sell itself at a fire-sale price. Manuel tried to more defensively position his portfolio by tilting it in favor of insurers, but with AIG as his top insurance pick, that move backfired as well.

Fidelity only recently added Hesse, also manager of  Fidelity Select Brokerage & Investment (FSLBX), as comanager of Select Financial Services. The market has dealt Hesse a very tough hand at Select Brokerage & Investment, but he deserves credit for reducing the fund's exposure to investment banks in late 2007. He's also shown signs of good, independent thought. While Manuel was buying shares of Bear Stearns in February 2008, Hesse dumped his fund's stake entirely before the month ended, sparing the fund the pain of Bear's March 2008 collapse. Hesse could be a positive addition to Fidelity's financials leadership, but it's too soon to tell.

I'm pretty sure how managers play financials now and in the near future will have a big impact on returns for years to come. And if Fidelity managers are apprehensive about their firm's research, I'm concerned they won't be in as strong a position to take advantage of the downturn as they should be. Having the chance to speak with Manuel, Hesse, and the other financials-focused Select fund managers might help boost my confidence, but Fidelity wouldn't make any of them available for an interview when we asked in September.

What Should You Do?
In confronting just about any crisis, you face only two choices--fight or flight. The flight response in this instance would involve moving your portfolio into cash. If you flee, you're locking in your losses at a moment when stocks are more likely to be closer to the bottom than the top. Moreover, you'll have to the none-too-easy task of deciding when to get back into the market. None of us will know when the next bull market has begun until it's well under way. Often the biggest returns come at the beginning of a rebound, and if you're out of the market, you'll miss out.

Staying in stocks will require a strong stomach. But as the great investor Shelby Davis (no relation) once put it, "You make most of your money in a bear market. You just don't realize it at the time." What he meant was that bear markets afford you the opportunity to buy great investments at bargain prices. As I noted earlier, buying beaten-down stocks isn't necessarily Fidelity's strong suit. But that doesn't mean Fidelity investors need to be left in the cold. Fidelity's no-transaction-fee FundsNetwork offers access to some terrific bargain-hunters.  FPA Crescent (FPACX) manager Steve Romick saw the housing bust coming from a mile away and has spared his shareholders the brunt of the collapse. Because he invests in securities of all stripes, including stocks, preferred stocks, and high-yield bonds, Romick has the advantage of flexibility. I'd also consider  Third Avenue Value (TAVFX), which is famous for its ability to sift through distressed situations. It's available through Fidelity's FundsNetwork, though outflows are whittling its cash stake, which could limit its ability to pounce on opportunities.

I still think we're in the early innings of this credit crunch. Its implications, and those of Washington's much-discussed $700 billion Wall Street rescue, are yet to be fully known. In the coming months, I'll be discussing more what it means for Fidelity and your portfolio in the Fidelity Fund Family Report. In the meantime, I'd hang on tight and take your Pepto-Bismol. You'll need it.

For more commentary on fund families and the financial crisis, see our recent Investing Specialist article on American Funds.

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