Fidelity Delving Into Private Companies

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investments in some private companies have been popping up in a handful of Fidelity funds. Joining me to discuss this news and to share a midyear performance update is Katie Reichart. She is a senior analyst with Morningstar.

Katie, thank you so much for being here.

Katie Reichart: Great to be here.

Benz: Katie, let's start by discussing this news of some nonpublic companies popping up in a handful of Fidelity funds. Let's discuss the funds that seem to be delving into some of these private companies and also just how large these stakes are.

Reichart: Sure. We're seeing this trend not only at Fidelity but at other mutual fund companies as well. Some of the Fidelity funds investing in private companies are large-growth funds like Fidelity Contrafund (FCNTX), Fidelity Growth Company (FDGRX), Fidelity Blue Chip Growth (FBGRX), Fidelity OTC (FOCPX), Fidelity Trend (FTRNX), and Fidelity Magellan (FMAGX), just to name a few.

Benz: Let's name some of the companies that you're seeing in some of these portfolios.

Reichart: Well, a big one right now is Uber, which has been in the news quite a bit, and then others are Pinterest, Airbnb, and SpaceX.

Benz: What's the potential benefit to the funds of getting in on some of these nonpublic companies early?

Reichart: It helps them see a longer runway for growth. We are seeing a lot of companies wait to go public in this market because they are able to raise money in the private market. So, mutual funds that invest are able to get in on that runway for growth. Some managers also say that it kind of helps them with other investments they might own in the portfolio. It helps them do some competitive analysis. So, those are some of the reasons.

Benz: These aren't large positions at this point?

Reichart:  No, they are not. By SEC law, mutual funds can have as much as 15% of assets in private companies, but we don't see them at that level at all. Usually, it's just a couple of percentage points of assets in each fund.

Benz: Let's discuss some of the risks because this does remind me of when we saw a similar phenomenon going on back in the late '90s--the dotcom era. Let's discuss some of the perspective risks, even though these positions aren't very large at this point.

Reichart: One risk is liquidity risk. You can't really sell these positions. And even sometimes after the IPO, there might be a lockup period for some of these companies. And then, of course, valuation risk from a couple perspectives: For one, some of these companies are really seeing soaring valuations right now. So, that's a risk for when it comes time for an IPO, maybe they can't live up to those expectations; maybe some companies don't even make it to an IPO--that's always a risk. And then even pricing of these assets, since they're not publicly traded, each fund company might do it a little differently. That's a risk as well.

Benz: I know that you and the team have been monitoring firms' practices when they do own these nonpublic companies--how they arrive and how they should price them. How do they do it so that it's fair and, to the greatest extent possible, reflects the true value of the company at a given point in time?

Reichart: It can be a little opaque to people outside the firm. A lot of big mutual fund companies like Fidelity have pricing committees, and the portfolio managers aren't sitting on those committees. It's a separate independent group, and they can price those as often as daily. They often look at the latest financing round for these private companies and base their estimates off of that--although sometimes they may be adjusting those numbers based on liquidity or other factors.

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Benz: Based on what's happening in the market a little a bit, too, I would think.

Reichart: Exactly.

Benz: In other Fidelity news, you and the team gave a couple of funds new ratings. Let's talk about those funds and how you arrived at their current ratings.

Reichart: We initiated coverage on Fidelity Value Discovery (FVDFX), and that is rated Bronze. Sean Gavin has been manager there for about three and a half years, and Fidelity has really taken steps to improve their value lineup. They've made some manager changes at some funds over the past few years. This was one of them. He has a quality-oriented process. The fund has held up very well during his tenure, and we've give it a Bronze rating.

Benz: The other fund, Fidelity Mid Cap Value (FSMVX), is not quite as positively rated. It's rated as Neutral. Let's talk about that fund.

Reichart: That fund has done quite well during the past couple of years. Court Dignan manages it. With a tenure of only two years, we're just being a little cautious to see how he settles in at that fund.

Benz: Moving over to performance, you took a look at performance by asset class on a firmwide basis. Generally, it's been a pretty positive picture so far this year. Of course, it's just a six-month period that you are looking at, but let's talk about that.

Reichart: The numbers look really strong across asset classes. If you look at U.S. equity, about 72% of the equity funds beat their category averages. For international equity, it's right around 69%. Fixed income is about 65%. And for allocation funds, 85% beat their category averages. So, it's certainly a strong trend.

Benz: And that's particularly strong when you consider that for some of these very large firms, it's difficult for them to have a high percentage of their funds above average.

Reichart: And especially with Fidelity, with such a large lineup, it can be difficult to have strong numbers across the board.

Benz: You took a look at some of the funds that are having particularly strong years in 2015. At the top of the list is one that we've talked about before--it's Fidelity Advisor Biotechnology (FBTAX) riding that wave in biotech stocks.

Reichart: That's been a really hot area of the market--that fund is up about 26% in the first six months of the year. It's Fidelity's best absolute performer, but it has also done really well in its health-care category, so it has done well with stock selection, too. And that's an important fund since lot of the large-growth managers do invest in biotech. It's good to see some strength coming from that fund.

Benz: We probably also want to caution people, though, not to drive with the rearview mirror. That sector has been so hot for so long.

Reichart: You don't want to pile in. It's been a really strong part of the market for a several years now.

Benz: Right. Fidelity Overseas (FOSFX) is another name that hit your radar when you were looking for some of the funds that have had really great performance so far this year.

Reichart: Yes, that one is up about 11% in the first six months versus the MSCI EAFE's 5.5%. So, it's near the top of its foreign large-blend category. And again, good stock selection there has really helped. That's a Bronze-rated fund. The managers have a pretty good record.

Benz: Fidelity Small Cap Stock (FSLCX), a Bronze-rated fund, is also having a pretty good showing so far in 2015.

Reichart: Yes, that one is up almost 9% versus the Russell 2000, which is up about 4.8%. Lionel Harris has run that since 2011. He had a couple of rough years out of the gates; but over the past year and a half or so, the fund has really stated to improve.

Benz: You took a look at Fidelity's actively managed funds--how they are performing, how they have performed recently. You are keeping an eye on what you think is a pretty positive trend there.

Reichart: I think this year, certainly, we've seen a lot of their active equity funds outperform their benchmarks. And that's after a couple of years where we've heard so much about passive funds and how that's the way to go, so I think that's encouraging for Fidelity and all active-equity investors.

Benz: In general, would you say that Fidelity's growth bias on some of these funds has probably given it a boost that may not be there in the future?

Reichart: That's certainly a possibility. Growth has been such a strong area of the market. Besides Fidelity's large-growth funds, a lot of the other funds--even their large-blend funds--can lean toward growth.

Benz: Moving over to funds that have lagged a little bit so far this year: Fidelity New Millennium (FMILX) is one. As you said, most of the funds are doing relatively well, but New Millennium is one that has struggled a little bit.

Reichart: This one has an S&P 500 benchmark, and it has beaten that for the first six months of the year. But it's in the large-growth category, and it's in the bottom third of that category. Part of the reason there is that it has a much larger energy stake, which has weighed on results recently.

Benz: Let's take a look at some of the very large funds that pop up in a lot of people's portfolios and in a lot of 401(k) plans. Let's start with Fidelity Contrafund.

Reichart: Contrafund is up about 5% in the first six months versus the S&P's 1.2%, so it's doing quite well. It's also doing well relative to its large-growth peers. As we mentioned before, it has some investments in Uber and other private companies, but it has also done well in its public-company stock-picking, too.

Benz: Fidelity Low-Priced Stock (FLPSX) is another widely held fund at the firm.

Reichart: That's up about 4.3%, so it looks good in its mid-value category--although that's one that's hard to really benchmark. It tends to have a large foreign stake, which helped results for the first half of the year. We'll see, going forward, with some of the turmoil overseas; but it's been doing well this year.

Benz: Katie, thank you so much for being here to share your insights.

Reichart: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.