Fundamentals Still Favor Stocks Over Bonds

Russ Kinnel: Hi, I'm Russ Kinnel, director of manager research for Morningstar. I'm joined today by Ramin Arani, manager of Fidelity Puritan, which has a [Morningstar Analyst Rating of Bronze and a 4-star rating].

Ramin, I want to start off by asking you a question: Is running the equity sleeve of a balanced fund different from running just an equity fund without a bond sleeve attached?

Ramin Arani: Russ, great question. For the last seven years before I ran Puritan for the last five, I ran an equity-only fund--the Fidelity Trend Fund. In some ways, that was very different because all I had to do was worry about what equity investments to populate the fund with.

While Puritan is a balanced fund, I have to set the asset allocation between equities, investment-grade fixed income, and high-yield fixed income. Within that, when I run the equity sub-portfolio, it's a little bit different from when I ran the Trend Fund.

Though, I would say my fundamental philosophy in process is the same. I continue to look for companies that are going to show better earnings growth and more earnings power over time than the market expects. It's exactly what I did when I ran Trend; that's also how I invest the equity assets of the Puritan Fund.

That being said, the neat thing about Puritan being a balanced fund is that you can think about the investment-grade sub-portfolio as providing a nice base level of income for shareholders of the fund. Think of it like the foundation of a house. In tough times, the foundation will be there, it will be the bedrock, it won't lose you capital, and it should generate at least a couple of percent of income.

Then, think about the equity sub-portfolio as the main floor of the house. It layers on earnings growth and dividend growth over time, which should then [bring in]--for the shareholder and the fund--nice growth and capital appreciation on top of the income. Then, think about the high-yield component of the fund as an opportunistic kicker.

So, when the opportunity presents itself, [the high-yield component] can add the penthouse pool to the house--some neat feature that really makes the house exciting when the opportunity presents itself. Given that construct, as I build the equity sub-portfolio, I think about it within that framework, which is obviously different than if you were just running an equity fund.

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Kinnel: You're also setting the asset allocation, which is different. I know the fund starts with a neutral 60% / 40% stock-to-bond mix. Where are you today? And what led you to that current weighting?

Arani: Russ, you're absolutely correct. The neutral allocation is about 60% equities and 40% bonds. You should think about the fund operating within a 10 point band around those neutral points. So, thinking about the equity sub-portfolio: If I'm less positive on equities, [the percentage of equities in the portfolio could be] less than 60% all the way potentially down to 50%; if I'm more positive on equities than bonds, you should think about the equity sub-portfolio being as much as 70% as opposed to a neutral 60%--obviously, there is room in between.

Really, since the spring of '09, the fund has been overweight on equities; it's been more than 60% equities. In the last two years, it's been over 65% equities. In the last year-plus, it's been about 70% equities. So, I've clearly favored equities for the last five years and even more so in the last two--really since the summer of 2011, which was a bit of a choppy period. Coming out of that, I began to feel much more positive about equities relative to bonds. So, that's been the allocation for the last couple of years, which has served the fund shareholders well.

As we sit here today, I'm no longer at max 70% [equities]; I've eased off of that a bit. But certainly as I look at relative fundamentals and relative valuation, I think it favors equities over bonds over the next two to three years.

Kinnel: Within equities, what are some of the areas in which you are finding attractive stocks?

Arani: Health care is a big point of emphasis in the fund--it has been for the last, I would say, three or four years. Biotech had been a very big bet in the fund for the last several years. We have an amazing health-care team, excellent biotech analysts, who I think very correctly identified companies that were going to bear tremendous fruit from their pipelines, which was going to yield much stronger earnings than the market anticipated or appreciated.

As we sit here today, that biotech bet is a bit smaller than it was because a lot of those companies have played out quite well, valuations have expanded. But it's still an overweight in the fund because there is still a number of names that I think still look attractive.

Within health care, there are quite a few specialty pharmaceutical names that have enjoyed some M&A [mergers and acquisitions] activity. That M&A activity, I think, increases the visibility, sustainability, and the earnings power of those companies beyond what the market is currently appreciating. So, those are part of that overweight in the fund as well.

Consumer discretionary had been a significant overweight in the fund. Coming out of the crisis, it tends to be an earlier cycle space. A lot of retail names. A lot of media names. I've been working that down over the last two years. As we sit here today, consumer discretionary is actually an underweight in the fund. Within that, media is still an overweight in the fund. So, media really is the bulk of the consumer discretionary positioning. But having sold a lot of retail stocks that did quite well early in the recovery, the overall consumer discretionary bet is now negative one.

The last space I would highlight--which is really more of a recent increase in the bet of the fund--is that I've taken energy from an underweight to now somewhat of an overweight over the last year, as we're finding some really exciting opportunities in the E&P [exploration and production] space: companies with great resources where they are accelerating production of oil and gas, and a lot of the services companies that are benefiting from that increased drilling production and exploration activity. We think that space is poised to do well over the next couple of years.

Kinnel: I'm kind of curious about your process. When I think about even the average investor sitting at their laptop, there's a tremendous amount of information at their fingertips. If you're a Fidelity manager, you have reports coming in from hundreds of analysts--you have quite a few companies visiting your offices every day. Obviously, there's sell-side research, there's just tremendous amounts of information coming to you. How do you manage through all of that information? How do you make good use of that and use it effectively?

Arani: I work very closely with our research department. We have 170 analysts around the world covering every sector, every industry--thousands and thousands of companies. Working closely with them really helps me focus on the opportunities that are most interesting and most exciting. So, if they can help me focus on the best opportunities, that makes it easier for me to then cut away the clutter and really focus on the opportunities that are going to make the most money for our shareholders.

I spend a lot of time on the road traveling--about 40% of my time. I travel often with our analysts, visiting companies, spending time on the road. Ironically, while being out of the office sometimes creates more work because you can't ignore everything else going on in the world while you're not there, at the same time it forces you to have clarity and to focus on what you are working on at that moment--not to be distracted by the 300 emails coming in and the other meetings that might be going on back in the office.

If I'm on the road and I'm visiting five companies in a day, my focus that day is on those five companies. And that also helps maintain my focus. By doing that, we gain a greater understanding of what those companies are doing, where they are likely to be going over the next couple of years, and it allows us to build more conviction in those ideas. Then, once you have that conviction, you're less prone to be distracted by other things because you're focused on what's important.

Kinnel: You've been at Fidelity since--was it 1992?

Arani: '92, yes.

Kinnel: Could you pick out one or two ways in which Fidelity has changed overall in that time?

Arani: Boy, it's changed a lot. When I started at Fidelity, we were at 82 Devonshire Street [Boston, MA], which was our headquarters building at the time. We were two to an office with a Quotron in the hallway. You had a rudimentary PC where you could build a spreadsheet on Lotus [software]. There were wires hanging from the ceilings; you could barely navigate the floor without tripping over wires and cables on the floor.

We were small. And one would think, as we've gotten bigger, that things might've gotten tougher. I think, certainly, the market has gotten tougher in the last 20 years. Twenty years ago, I remember calling companies where you talk to the CFO of a company, and you were maybe the first investor to call him in three months. So, just by having a conversation with him, you learned a lot that the rest of the market [didn't know]. Anybody could call him. Certainly, he would tell the same thing to anybody, and it wasn't anything that wasn't publicly known. But yet, the number of investors was just a smaller group.

As we sit here today, you now have thousands and thousands of investors calling these same companies. A lot of them have different time horizons than investors did back then. And you have a lot of hedge funds now; you have a lot of index funds now. You have a lot of investors that are more short-term oriented and the industry has changed.

How has Fidelity changed in response to that? I think the core philosophy of knowing our companies better than anybody else has remained. And I think that's been an important thing to maintain. At the same time, our horizon--our view--has changed. I think, because the market is so short-term oriented, we now have the luxury to be able to take a longer-term view--let's say at least a two- or three-year view. And often, that is how we take advantage of opportunities and put up outsized returns--because we're able to take advantage of short-term gyrations that are driven by short-term trading activity and, with a fundamental view that goes out two to three years, if we're right--and we're not always right--but if we're right, that's how we make money for our shareholders.

So, that all starts with our core philosophy around knowing our companies better than anybody else and betting big behind ideas where we have conviction.

Kinnel: Ramin, thanks so much for taking the time.

Arani: Thank you, Russ. I appreciate it.