An Unusual Take on Emerging-Markets Stocks

The following is our latest Fund Analyst Report for Fidelity Emerging Markets Fund FEMKX. 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 Emerging Markets has an accomplished manager, low costs, and an impressive record during its leader's tenure. It retains its Morningstar Analyst Rating of Bronze.

This fund takes an unusual slant on the emerging-markets field. If manager Sammy Simnegar, who has run this fund since October 2012, likes a company in the MSCI Emerging Markets Index, he will weight the stock at the index weighting plus 50 basis points (half a percentage point). When he doesn't like a company, he usually won't own it at all. (In a recent tweak, he says in rare cases he'll now own half-weightings of the biggest index components because the risk of having 0% has become too great, as the index weightings of some tech-sector giants have surged above 4%.)

He also will own companies that aren't in the index at all; the fund typically has 10%-15% of assets in firms based in developed markets that have much exposure to emerging markets. He wants companies that show strong, sustainable growth without requiring much borrowing and also looks for traits such as strong free cash flow and price momentum to varying degrees. This approach isn't without its risks; in its most recent portfolio the fund had roughly 30% of its assets in the technology sector--even more than the index's stake--and tends to have high valuations in general.

This strategy has paid off. During Simnegar's tenure, from Oct. 15, 2012, through Sept. 30, 2017, the fund's 7.3% annualized return is far ahead of the index and the average for the diversified emerging-markets Morningstar Category, which posted gains of 4.1% and 3.9%, respectively. The fund accomplished this while suffering milder losses during downturns than its average rival. A low expense ratio has helped. (Simnegar also has posted a strong record in nine years at Fidelity International Capital Appreciation FIVFX using a similar strategy.) However, this fund's huge stake in high-flying Internet and tech firms and general willingness to carry above-average valuations means its moderate-volatility past shouldn't be taken as a guarantee that it will provide a cushion against rough spots in the future.

Process Pillar: Neutral | Gregg Wolper 10/16/2017 Sammy Simnegar, this fund's manager since Oct. 15, 2012, has an unusual approach. When he owns companies in the MSCI Emerging Markets Index, he will overweight them by about 50 basis points. But if he doesn't like a company, he won't own it at all, except in rare cases when the stock takes up such a large weighting in the index--around 5% or more--that he'll own a half-weighting rather than nothing. He looks for firms poised to benefit from "mega-trends" such as "digitization" and increasing middle-class consumption. He looks for firms with traits such as rising earnings per share and dominant positions in their field, along with quality metrics, such as return on invested capital and strong balance sheets. He rebalances once a week to maintain desired allocation levels, resulting in an above-average turnover rate. But that rate has fallen as he's reduced the frequency of his rebalancing. The fund's country and sector weightings can vary greatly from those of the index or peers.

He often has a significant chunk of assets in developed markets-domiciled companies that have substantial emerging-markets exposure. Simnegar favors steady-growth sectors such as consumer staples and healthcare; he treads lightly in utilities and energy, especially big state-owned firms. The eclectic nature of the strategy and its aim of limiting losses are admirable but require exceptional ability to succeed. Thus, the fund gets a Neutral Process rating.

Manager Sammy Simnegar's portfolio looks like the MSCI Emerging Markets Index when one looks at the weightings of many specific holdings, for no matter how much he likes a company, he'll overweight it by no more than 50 basis points (half a percentage point). But because (with rare exceptions) he will avoid owning an index name at all if he doesn't feel very positive about it, and will also own plenty of out-of-index companies--including many domiciled in developed markets--the overall portfolio has many differences with the index. For example, in the latest portfolio (Aug. 31, 2017), the fund had only about half the index weightings for Taiwan and South Korea. It had about 15% of assets in the United States and developed European markets. And the stake in Morningstar's consumer defensive sector was roughly double the index's weighting, because Simnegar has been concerned about the prospects for global economic growth. That sector also is a typical favorite hunting ground for him, because of the chances to find strong, stable growth companies. Conversely, he dislikes the energy sector because it requires so much capital spending and is less reliable, and that is deeply underweight now. As usual, the fund's valuation metrics, such as price/earnings and price/book, are substantially higher than the diversified emerging-markets category average. But so are the portfolio's growth figures--which captures a key element of Simnegar's approach.

Performance Pillar: Positive | Gregg Wolper 10/16/2017 The relevant time period for evaluating the performance of this fund is the past five years, because manager Sammy Simnegar took the reins in mid-October 2012 and immediately changed its strategy. And during that period, the fund has posted a strong showing. From Oct. 15, 2012, through Sept. 30, 2017, the fund has achieved a 7.3% annualized return, far ahead of the MSCI Emerging Markets Index and the diversified emerging-markets category average, which posted gains of 4.1% and 3.9%, respectively. The fund accomplished this while suffering milder losses during downturns than its average rival. That is shown by its downside-capture ratio versus the category average. The fund receives a Positive Performance rating.

There are some caveats, however. The main one is that Simnegar regularly invests a significant portion of the fund in companies that are domiciled in developed markets rather than emerging markets, as long as emerging markets make up a substantial portion of their business. At times that has benefited the fund, but that effect can reverse. During the past 12 months, the fund's overweighting in some of the biggest names in the Internet and tech arena--such as Tencent and Alibaba--has been a boon as those stocks have soared. But with a 30% stake in the tech sector as of its latest portfolio, the fund is vulnerable to a turnaround in sentiment.

People Pillar: Positive | Gregg Wolper 10/16/2017 Sammy Simnegar has been the sole manager here since Oct. 15, 2012, when he replaced Bob von Rekowsky. Simnegar has much experience, first as an analyst and then as a portfolio manager. He has been with Fidelity since 1998, when he was hired as an analyst out of business school, covering REITs and eventually other U.S. sectors including regional banks. In 2003, he shifted to covering companies in emerging markets. In January 2008, Simnegar was named the manager of Fidelity International Capital Appreciation, a fund that he still runs. His record there has been strong, especially after a shift of strategy in 2010 that led to the approach he still uses there and at this fund as well. That fund's trailing five-year return through Sept. 30, 2017, tops 90% of its foreign large-growth peers. That fund has typically had an unusually large emerging-markets stake of around 20% of assets. But Simnegar had not managed a fund focused entirely on emerging markets until taking over this portfolio.

Simnegar does not have a team of analysts dedicated specifically to this fund, but rather researches companies himself working in conjunction with Fidelity analysts stationed around the world, as well as holding discussions with other Fidelity portfolio managers. Simnegar's experience and care in constructing and implementing his unusual approach plus the heft of the analyst group earns the fund a Positive People rating.

Parent Pillar: Positive | 04/18/2017 Long one of the industry's biggest asset managers, Fidelity has faced pressure as investors have pulled money from the active U.S. equity funds for which the firm is best known. While significant outflows could gravely impact some firms, Fidelity is shielded by its diverse mix across asset classes (including its own competitively priced index funds), success in other business lines, and private ownership that helps it escape quarterly earnings scrutiny.

The asset-management division remains well-staffed amid cost-cutting across the firm. Still, the firm could stand to rationalize its active-equity fund lineup: There are many redundant or mediocre funds alongside the standouts run by longtime star managers and up-and-comers. Retaining talent remains critical, particularly following the unexpected retirement announcement of a talented young small-cap manager. To its credit, Fidelity has handled equity manager transitions better than in the past. Meanwhile, Fidelity's fixed-income division remains among the industry's best, with a team-oriented approach assuaging key-person risk. Fidelity's target-date funds have improved, and the firm's technology and trading resources remain topnotch.

Even as it has raced to address competitive headwinds by unveiling a handful of factor-based exchange-traded funds, Fidelity remains capable on the actively managed side, earning a Positive Parent rating.

Price Pillar: Positive | Gregg Wolper 10/16/2017 This fund's cost is not nearly as high as those of most actively managed emerging-markets offerings. The expense ratio for its no-load retail shares for 2016 was 1.00%, and its latest prospectus pegged the expense ratio at 0.99%. Those figures include performance-based fees, yet are still far below the 1.37% median for emerging-markets funds offered without a load and land in the least-expensive quintile of that comparison group. The K shares, for retirement accounts, are also inexpensive compared with similar share classes. As a result, this fund receives a Positive Price rating.