Fidelity Small Cap Discovery Downgraded as Myers Exits

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Manager Chuck Myers will step down at the end of 2017. While there's a reasonable transition plan and successor in place, his departure is a big loss. We have downgraded the fund's Morningstar Analyst Rating to Bronze from Gold.

From Myers' 2006 start through January 2017, the fund's 10.8% annualized gain led nearly all small-blend Morningstar Category peers and beat the Russell 2000 Index by 3.5 percentage points. With a mostly sector-neutral approach, Myers' stock-picking shone through. His Buffett-inspired approach's focus on valuations and margin of safety provided downside protection.

This type of transition isn't new for successor Derek Janssen, who joined Fidelity's small-cap team in 2007. Janssen joined Myers as a comanager at

Janssen doesn't have a long track record of his own, but he's made thoughtful decisions at Fidelity Small Cap Value. His approach is similar to Myers', with a higher-quality bent and a focus on factors such as CEO ownership of shares and capital allocation. Janssen made some stock-specific changes upon taking over Small Cap Value but kept portfolio construction and the fund's risk profile similar. Its bottom-quartile finish in 2016 (despite a 21% gain) isn't overly concerning considering the strategy isn't built to lead the way in a strong market.

Janssen's biggest adjustment will be a new benchmark, the Russell 2000 Index; it holds fewer financials and more healthcare and technology than the Russell 2000 Value Index. This fund is also twice the size of Fidelity Small Cap Value. But on the plus side, it's closed to new investors, and Janssen has a year to adjust to his new role.

Process Pillar: Positive | Katie Rushkewicz Reichart, CFA 02/01/2017 Chuck Myers and successor Derek Janssen use a value-oriented strategy that isn't commonplace at growth-driven Fidelity. They focus on out-of-favor stocks with low expectations and are willing to hold on to them for years while waiting for price appreciation. Taking a page out of Warren Buffett's book, they invest only in businesses they understand and incorporate a margin of safety into their stock picks. Myers has executed this approach well in various market environments. Janssen worked alongside Myers at Fidelity Small Cap Value in 2013-16 and learned Myers' process, which helps the fund maintain a Positive Process rating despite Myers' upcoming departure.

Sector weightings are kept within close range of the Russell 2000 Index so that stock-picking drives performance (though industry weightings, including in REITs, have deviated more). However, that hasn't made the fund a benchmark-hugger, as its relatively high active share indicates. The fund is relatively compact, with 55-75 stocks, so it was encouraging that following significant asset growth it closed to new investors as of Jan. 31, 2013.

Fidelity Small Cap Value didn't see significant changes to its process when Janssen took over as lead manager, but he tends to be more quality-oriented than Myers. He'll work alongside Myers in 2017, so major changes at the transition date are unlikely.

This fund falls in the small-blend category, but it's historically skewed toward the border of the small-value side of the Morningstar Style Box. It typically stays close to the Russell 2000 Index's sector weightings as a risk-control measure so that stock-picking drives results. Under Chuck Myers, that paid off for the fund, with strong stock-picking driving outperformance. Successor Derek Janssen has a shorter tenure at Fidelity Small Cap Value, but he develops in-depth theses for each potential holding and closely tracks developments to make sure he's owning companies for the right reasons, indicating an introspective process.

Janssen didn't overhaul the portfolio when he replaced Myers at Fidelity Small Cap Value, but he did make some changes to positions. He tends to be a little more quality-oriented than Myers, favoring a wider margin of safety (especially if he thinks he's not getting paid to take risk) and sold a few names that Myers continued to own here, such as TCF Financial TCB.

Janssen prefers companies where the CEO's compensation is driven more by stock than cash, and good capital allocation from company management is key. He thinks it's a plus that Dillard's DDS has a lot of family ownership, which helps align management's interests with shareholders'; it also has a good record of returning capital and owns the real estate of its stores.

Performance Pillar: Positive | Katie Rushkewicz Reichart, CFA 02/01/2017 It's hard to argue with Chuck Myers' success. Since taking over in March 2006 through January 2017, the fund gained 10.8% annualized to the Russell 2000 Index's 7.4%, placing it near the top of the small-blend category and earning a Positive Performance rating. It finished in the category's bottom half in 2006 and 2007 when Myers favored a more top-heavy portfolio that got burned by a few troublesome big positions. Since then, he's avoided making huge bets on individual stocks or sectors, and his stock-picking has shone through. The fund landed in the category's top 12% or better in every calendar year from 2008 to 2012, a remarkable feat given the variety of market conditions. Perhaps even more impressive was the fund's performance in 2008 and 2009, a period when many funds did relatively well in one year or the other but not both. This fund bucked the trend, losing significantly less than its average peer in 2008 but gaining 50% in 2009--nearly 20 percentage points better than the category norm--as some opportunistic moves played out. When more-speculative growth names are in favor, its performance can look a little sluggish. It landed in the category's bottom half in 2015 and 2016, underperforming because of poor financials and consumer discretionary picks. Myers will step down in December 2017, but the fund retains its Positive Performance rating and strong risk-adjusted record for now.

People Pillar: Neutral | Katie Rushkewicz Reichart, CFA 02/01/2017 Chuck Myers, who's run the fund since March 2006, will step down at year-end 2017. Myers took a six-month leave of absence in 2016. Derek Janssen, to whom Myers handed off Fidelity Small Cap Value in early 2015 after working alongside him since 2013, covered for Myers during a sabbatical and has remained a comanager on this fund since then. Janssen will become sole manager when Myers departs and will eventually hand off Fidelity Small Cap Value to another manager.

The fund receives a Neutral People rating because Janssen isn't as much of a known quantity as Myers. It's encouraging that Janssen had three years to get up to speed on the process and portfolio before becoming sole manager of Fidelity Small Cap Value, but it's still early days in his role as sole manager.

Janssen joined Fidelity's small-cap team as an analyst in 2007 and covered small-cap industrials and tech stocks. He spent two years in Fidelity's Tokyo office before returning to Boston in 2010. Previously, he worked at two different hedge funds, including one with a small-value orientation. Fidelity's small-cap team includes about 20 analysts and managers in Boston, London, and Tokyo. Janssen invests more than $1 million in Fidelity Small Cap Value and $10,001-50,000 in this fund.

Parent Pillar: Positive | Katie Rushkewicz Reichart, CFA 10/14/2015 Industry giant Fidelity is well resourced and remains an industry leader in technology, trading, and its brokerage platform. Its fixed-income division has been stable and features funds with strong long-term risk-adjusted records. The sprawling equity lineup hasn't always been as consistent beyond some of its most well-known managers. But the equity division has shown signs of stabilizing since the 2007-09 financial crisis. Performance and manager tenure have improved, and Fidelity has handled manager changes more carefully. The equity analyst team is now more experienced overall, and there's evidence that the build-out of the international-equity team has borne fruit. The effort to carve out value and equity-income teams should serve investors well.

Even so, the huge fund lineup leaves room for some mediocre funds. The firm also has much to prove with its revamped target-date funds, which have lost market share to competitors following weak performance and have since undergone management changes and process tweaks.

Still, Fidelity is headed in the right direction. The funds’ boards and managers have made consistent performance and manager ownership a priority. The lineup remains reasonably priced. Improvements on the equity side are encouraging, and its fixed-income funds remain among the industry's best. Fidelity earns a Positive Parent rating.

Price Pillar: Positive | Katie Rushkewicz Reichart, CFA 02/01/2017 This fund has a performance fee, so its expense ratio can change based on how its three-year returns look relative to the Russell 2000 Index. (For every percentage point of out- or underperformance, the expense ratio is adjusted by 0.02%, up to a maximum of 0.2%.) The performance-based fee is in the interest of investors, who don't have to pay as much when the fund is underperforming. Without considering the performance adjustment, the fund's expense ratio is reasonable, so the fund earns a Positive Price rating. Strong performance during the past several years has meant a higher expense ratio at times, but it's still been competitive versus similarly sold peers.