A Thoughtful, Well-Researched Approach to Healthcare Investing

The following is our latest Fund Analyst Report for Fidelity Select Health Care FSPHX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Fidelity Select Health Care's experienced, knowledgeable manager, deep resources, distinctive process, and relatively low costs earn the fund a Morningstar Analyst Rating of Silver.

Manager Eddie Yoon seeks firms that can grow cash flows rapidly. He divides the portfolio into several different portions, giving more-stable stocks heavier weightings even though he prefers companies with greater growth potential, such as selected biotech and medical-equipment stocks. The latter tend to have more unpredictable fundamentals, so Yoon gives them lighter weightings in the fund's portfolio, which ranges between about 90 to 110 stocks. The largest holdings can get quite a hefty weighting, but they aren't necessarily the global pharmaceutical giants one might expect to be filling the slots reserved for "safer" picks; in fact, Yoon generally isn't fond of big pharma firms, citing potential regulations, loss of pricing power, and slow growth as factors working against them. Rather, the top holding as of June 30, 2018, with 9.9% of assets, was

Even more than the well-known names, the fund's holdings in less-predictable areas require extensive knowledge of the field. Yoon has approximately 15 years experience as a healthcare investor, including a decade running this fund. He also works with a team of about 15 Fidelity healthcare analysts. The fund's performance has been strong under Yoon. It topped the average for the healthcare Morningstar Category and the fund's benchmark, the MSCI US Health 25/50 Index, by comfortable margins over the trailing five-year and 10-year periods. It has not provided a smooth ride--the fund's returns have been more volatile than the index, though not the category average. So, this is a solid choice for a healthcare sector fund, with its relatively low cost adding to its appeal. But various factors--the many questions surrounding healthcare, the high weightings of top holdings, the unpredictable nature of biotech and other firms--mean its risks should definitely be kept in mind.

Process Pillar: Positive | Gregg Wolper 08/14/2018 Manager Eddie Yoon seeks firms he and his analyst team believe can generate ample free cash flow relative to industry peers. Yoon primarily looks for firms that can reduce costs in the healthcare system, though he also buys firms he believes can justify charging higher prices for innovative products.

Yoon splits the portfolio into three categories: stable firms with fairly steady growth prospects, faster-growing but established firms with focused product lines, and emerging companies with new and innovative products and services. Most of the fund's assets fall into the first two categories, while the fund spreads just 10%-15% of assets across the third, more-speculative category. Yoon and his analyst team develop normalized free cash flow estimates by forecasting sales growth and margins, and evaluate how well management allocates capital. The less predictable the cash flows, the lighter a stock's weighting in the portfolio. Thus the fund can have top holdings with weightings as high as 6% to 10% of assets, while at the other end of the spectrum, many other holdings get weightings of 0.3% of assets or less.

The process carries risks, but the way the portfolio is assembled is a thoughtful and well-researched way to build a portfolio in a complex sector, and it distinguishes the fund from its index and rivals. Overall the fund receives a Positive Rating for Process.

Manager Eddie Yoon has long believed that other areas of the healthcare universe offer better growth prospects than the giant pharmaceutical household names. True, he will own the latter; the fund had 14% of its portfolio in that subsector as of June 30, 2018 (according to Fidelity), and Yoon reports that he recently owned

Performance Pillar: Positive | Gregg Wolper 08/14/2018 For the trailing 10 years through July 31, 2018, which essentially covers the tenure of current manager Eddie Yoon, this fund posted a return of 16.2%, three percentage points higher than the return of the MSCI US IMI/Health Care 25/50 Index (the fund's benchmark.) The fund's return also surpasses the average of the Health Morningstar Category average by more than 2.5 percentage points per year, landing in the top quartile of that group. The fund's performance over the trailing five-year period is nearly as impressive. That said, it hasn't been a smooth ride by any means, which might be expected given Yoon's preference for rapidly growing firms, many in the biotech field, over more stable companies with less enticing future prospects. The fund's returns have been more volatile than the index over both periods by a substantial amount, though a bit less volatile than the category average. The fund's risk-adjusted measures are nevertheless strong, earning the fund a Positive rating for Performance.

The fund badly trailed its benchmark in 2008, falling 32% while the index lost 21%. It also lagged in the volatile third quarter of 2011 by 4 percentage points. In 2016, it turned in lousy results thanks to an above-average biotech weighting and stakes in

People Pillar: Positive | Gregg Wolper 08/14/2018 Investors in this fund get plenty of experience and a large team on their side. Manager Eddie Yoon has been a healthcare investor for his entire career. From 2002-07, he covered healthcare stocks at J.P. Morgan, serving as a co-portfolio manager from 2005-06. In May 2007, he joined Fidelity and was named manager of Fidelity Select Medical Equipment/Systems FSMEX, which he still runs. That fund has outperformed its benchmark nicely under his watch. Yoon took over this offering, and leadership of Fidelity's healthcare team, in October 2008.

Yoon draws upon the team’s roughly 15 members, of which 10 have subsector specialties, for support. In recent years, Fidelity added three region-focused healthcare analysts in Boston, London, and Hong Kong. This mix varies in experience, but the team’s most-seasoned members reside in areas where specialized knowledge is most necessary. Rajiv Kaul, the longtime manager of Fidelity Select Biotechnology FBIOX, and Eirene Kontopoulos, a biotech analyst who joined Fidelity in 2007 after earning a neuroscience doctorate, are key members. Karim Suwaan de Felipe, a comanager at Fidelity Select Pharmaceuticals FPHAX, joined Fidelity’s institutional arm in July 2010 and has a doctorate in molecular biology.

Yoon has more than $1 million invested in the fund. With deep resources and well-aligned financial interests, this fund earns a Positive rating for People.

Parent Pillar: Positive | Gregg Wolper 08/14/2018 Fidelity isn't without challenges but remains well positioned enough to compete in a changing industry. It earns a Positive Parent rating. The firm's diversified asset mix has shielded it from steady outflows from its active U.S. equity funds, with its taxable bond, international equity, and low-priced index offerings attracting assets. Its revamped target-date offerings have improved, and in 2018 the firm plans to launch an additional series combining active and passive funds to better compete in an area where investor interest has grown.

Attracting and retaining talented investment professionals is more important than ever. The equity division came under fire in 2017 amid reports of sexual harassment and a hostile work environment, leading to portfolio manager dismissals and a change in leadership. While Fidelity addressed the personnel issues and is working to improve collaboration through weekly team meetings, more-open floor plans, and improved feedback systems, it remains to be seen how the division may incorporate team-based elements into the legacy star-manager system. Meanwhile, the fixed-income division remains in steady hands following the retirement of a longtime CIO. While the bond analyst and manager ranks have seen more change than usual lately, the team-oriented structure of its investment-grade and municipal offerings helps minimize the impact of departures.

Price Pillar: Positive | Gregg Wolper 08/14/2018 This fund's expense ratio, which was 0.73% in the most recent prospectus, is a relative bargain among actively managed sector funds. As such, the fund receives a Positive rating for Price.

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