Inside FidelityGeoffrey Smith
Managing the world's largest mutual fund affords special privileges. After taking over Fidelity Investments' then $22 billion Magellan fund in 1992, Jeffrey N. Vinik visited Motorola Inc. In a whirlwind day, he had private meetings with Motorola's seven top executives, including then Chief Executive George M.C. Fisher, and grilled them on their business. On the plane coming back from Chicago, Vinik worked up earnings forecasts on a yellow legal pad--he doesn't know how to use computerized spreadsheets--and came to a startling conclusion: "I realized they were going to earn nearly double what [Wall Street] analysts were projecting."
How did he figure that? Both Vinik and a Motorola spokeswoman swear that no information was revealed beyond what is normally available to all investors. But Vinik was convinced that Wall Street was sharply underestimating demand for Motorola's semiconductors, both from foreign markets and from the cellular phone industry. Within four months, by March 1993, Fidelity had bought 7.4 million Motorola shares for about $250 million. Vinik was right on the money. The stock has more than tripled, producing huge gains, not only for Magellan but for dozens of other Fidelity funds whose managers followed Vinik's lead.
His savvy play on Motorola illustrates a lot about why Fidelity's equity mutual funds deliver amazingly strong returns and dominate the mutual-fund industry: brainpower, hard work, willingness to challenge conventional wisdom, and the ability to use its huge size to ferret out valuable information. Indeed, no other fund company approaches the Boston-based giant when it comes to investing the public's money in stocks. The flagship Magellan fund, now with $37 billion in assets, was the nation's top-performing fund in the 1980s. Even with its gargantuan size, Magellan manages to outrun hundreds of other funds with similar investment goals.
ONE IN FOUR. But Fidelity's successes go far beyond Magellan. The average cumulative return for its diversified U.S. equity funds over the past 10 years is 407.7%. Excluding Magellan, the figure only drops to 403.5%, according to Morningstar Inc., which tracks fund performance. Among the companies managing the most equity-fund assets, the closest to Fidelity is Twentieth Century Investors, with 375.7%. Although Fidelity's funds have trailed a few rivals in the past year, they have a commanding lead over the most recent three- and five-year periods.
Combine those bountiful returns with the fund industry's most sophisticated marketing operation, and it's easy to understand why Fidelity's stock funds now command 17.5% of all equity-fund assets, according to Strategic Insight Inc., a fund-industry consultant. Even more impressive is that in the first eight months of 1994, a time of jittery markets, Fidelity captured nearly one of every four dollars in net cash flow into all equity funds.
By almost every measure, Fidelity's stock-picking machine is the most sophisticated and successful that Wall Street has ever seen. It's built around the guiding principles set down by Peter Lynch, the now retired superstar portfolio manager of the Magellan fund. Lynch's investment philosophy is to immerse himself in a company's business and try to spot the significant changes ahead of the crowd. Lynch disdains trying to time turns in the stock market or the economy; he feels funds should almost always be fully invested.
Fidelity's stock-picking machine is fueled by unparalleled entree to corporate executives, state-of-the-art investment technology, the best Wall Street research--produced by Fidelity's huge flow of brokerage commissions--and an unusual corporate culture that motivates its talented portfolio managers to excel far beyond most of their peers.
For the past decade, mutual-fund pundits have warned investors that Fidelity's winning streak could not last, because its funds were becoming too large to outperform smaller, nimbler competitors. The more money under management, the argument goes, the harder it is, percentage-wise, to produce large returns.
Academics, further, argue that investment returns "regress to the mean"--or, in other words, all eventually just become average. But Charles A. Trzcinka, a finance professor at the State University of New York at Buffalo and a student of mutual funds, has forecast Magellan's regression for five years and it hasn't happened yet. "It's either tremendous luck or enormous management skill," he says. Whatever the case, Fidelity's equity operation continues to defy the odds.
BIG RISKS. Academics aside, the greater risk to Fidelity's primacy is a prolonged bear market. Aided by its aggressive, fully-invested strategy, Fidelity capitalized on the strong bull market to widen its lead over other equity funds. Whether Fidelity would do so well during a prolonged bear market is far from clear, for Fidelity has been taking some big risks that are not apparent to most of its investors--or even to Wall Street.
Much of its success has come from making large, concentrated bets. Fidelity now has 25% of its $140 billion in equity assets in just 30 stocks. Magellan, for instance, has 28.5% of its assets in technology stocks. During a three-day rout in tech stocks that began on Aug. 30, the fund lost some $650 million. The incident suggests how a severe downturn in technology could hurt not just Magellan, but Fidelity as a whole. All but a handful of Fidelity's largest growth funds have stakes of 10% or more in technology.
These concentrations could prove difficult to unload if the stocks or industries stumbled badly and investors wanted out. "If there were ever liquidity problems, there would obviously be price concessions" that would hurt the performance of their funds, says Mark Rowland of Rowland & Co., an Atlanta money manager. William J. Hayes, chief operating officer of Fidelity's equity funds says that the large concentrations will not create a liquidity problem. "It's not going to happen." The reason: "There are so many different [investment] disciplines here that people are always buying and selling at different times."
While industry concentration does pose some additional risk, Fidelity has been trying to offset that risk by diversifying into foreign markets. Many of its growth funds regularly invest a portion of their assets abroad, So far, the move has produced some snappy returns. The company has 50 investment professionals in London, Tokyo and Hong Kong.
That commitment of resources is typical of Fidelity. Indeed, access to information is perhaps the most important component of Fidelity's edge. How many fund managers could command the time that Vinik got at Motorola? Or how many fund complexes get visits from top executives of as many as 20 companies each day?
Fidelity's in-person sessions with top corporate executives can often prove decisive in making investment decisions. Eastman Kodak Co. is a good example. Fidelity managers had numerous meetings with its executives, especially then Chairman Kay Whitmore. During the past two years, Fidelity managers accumulated the stock because it looked cheap: Kodak had a strong cash flow and dominant share in its markets. At one point, Fidelity funds owned 8% of the company.
By 1993, as Kodak struggled with a restructuring, some Fidelity managers became skeptical of Whitmore's management style. They began asking more pointed questions and telling Whitmore what they thought should be done, such as sticking to its imaging business and shedding unrelated units. "They tear apart management's way of thinking," says Timothy P. Cost, Kodak's former investor relations director, who sat in on most of the meetings. Finally, convinced Whitmore wouldn't be able to turn Kodak around, Fidelity dumped its entire holding--at a profit. "He always disappointed us," says Beth F. Terrana, portfolio manager of the Fidelity Fund.
Another meeting with a company's top management led to one of 1994's most successful investments: American Cyanamid Co. Most Wall Street analysts had turned their noses up at the restructuring plan that CEO Albert J. Costello laid out earlier this year. But Charles A. Mangum, who runs the
Fidelity Select Health Care fund, was intrigued enough to attend a Mar. 15 investors' lunch with Cyanamid management, hosted by a brokerage firm. "I was impressed by [Costello's] aggressiveness," Mangum says, speaking of Costello's plan to sell certain units and refocus the business on others. His assessment: "The company was at least 50% undervalued."
Back at Fidelity the next day, he directed the trading desk to buy Cyanamid for his own fund. And he shared his epiphany with other managers. "I went from office to office, pitching the stock to everyone I could find." By mid-May, Fidelity funds owned 8 million shares at an estimated cost of $46 a share. In early August, American Home Products Corp. saw value in Cyanamid, too. It agreed to pay $101 a share for the company--a 120% gain for Fidelity shareholders.
SHARING IDEAS. Although Fidelity managers often buy in concert, they also tend to have different views on when to sell. Consider Entergy Corp., a natural-gas company that was one of Fidelity's major holdings in late 1993. Terrana and several other managers unloaded the stock when it peaked at $40 a share. But Vinik thought the boom in gas stocks would continue--and watched as the stock tumbled to about $30 before throwing in the towel. "Their earnings didn't come through like I thought," Vinik says. "I held on too long."
Fidelity managers are required to share ideas and information. The rationale: if everyone discloses his best ideas, it will help all the funds excel. Every morning, for instance, they get a list of all stocks bought and sold by the funds the prior day: On average, Fidelity trades $1 billion worth of stock in 1,000 companies every day. They also get summaries of every contact between a Fidelity staffer and a corporate manager, whether it was brief phone call or an all-day visit to a company's headquarters. "It's easy to suffer from information overload here," says Brian S. Posner, who runs the $7.4 billion Fidelity Equity-Income II Fund. "The challenge is to stay organized."
Sharing ideas also significantly eases the burden of managing Magellan and some of the other multibillion-dollar funds. Vinik says he closely follows 200 of the 550 stocks in Magellan. He relies on other Fidelity staffers to help keep track of the rest. Close cooperation between fund managers is also encouraged by the compensation system. Managers' income depends not only on what their own fund achieves but also on how other Fidelity funds do against the competition. And they are judged on how many winning ideas they contribute to the company. Managers can earn from $100,000 to $1 million a year, depending on the size of the fund and its returns.
To encourage informal communications, equity managers and analysts are packed in small offices on two leased floors of a downtown Boston bank. Their tiny quarters serve as a clearinghouse for investment ideas, and most are bursting with reams of financial documents. They typically work 12-hour days, often weekends, and travel frequently. "We learn here through osmosis," says Michael Gordon, who runs the $1.5 billion Blue Chip Growth Fund.
It's a high-pressure atmosphere, one capable of turning smart college graduates and MBAs into big-time money managers in just a few years--or sending them packing. Of some 700 applicants yearly, Fidelity hires only four or five. They're assigned to follow one industry, work closely with an experienced manager, and meet for an hour once a month with Peter Lynch, who now serves as a mentor. Analysts who make the grade are usually allowed to run an industry-specific sector fund within two years.
Because they get some of the best training in the investment business, Fidelity managers are actively courted by competitors. Surprisingly few leave. Terrana says that even huge paychecks promised by hedge funds, which can pay much more than mutual funds, aren't sufficient incentive. "I get calls from headhunters all the time, but could I really be as successful outside Fidelity?" she says.
FLYING DATA. Good question. For one thing, few competitors can offer Fidelity's technological and logistical support. All the managers and analysts have Sun Microsystems Inc. workstations on their desks that supply not only all of Fidelity's internal research but virtually all available Wall Street research and almost every electronic market-monitoring system. Fidelity's programmers are constantly coming up with ways to organize and analyze information. Their latest invention is proprietary software that can locate financial statements from any Securities & Exchange Commission filing and dump it in an electronic spreadsheet in a matter of seconds--even on an airplane.
Fidelity managers weighing outside offers also have to consider doing without other benefits of the fund group's enormous clout on Wall Street. With $300 million a year in commissions to spend, Fidelity is Wall Street's No.1 brokerage customer. That means it not only gets the best research but, as they say on the Street, tends to get the first call. There are other perks. When Duracell International Inc. went public in a heavily oversubscribed offering in 1991, Fidelity received 10% of the shares it wanted, while other investors got no more than 5%. Duracell's price rocketed 30% after the offering.
Fidelity can also demand that brokers put up their own money to accommodate its trading. That could mean buying a block of stock that Fidelity wants to sell even when there are no other buyers. "Brokers know we demand loyalty," says trader James J. Altoonian. "They usually go along." While not unusual for large investors, it's another way Fidelity gets an edge over smaller fund companies.
Some Wall Streeters claim that Fidelity uses its size and concerted buying strategy to push up the prices of stocks it thinks have potential. "If Fidelity likes a stock, it could become a self-fulfilling prophecy," says one prominent Boston money manager. "A lot of their returns have been created by their own buying," adds Atlanta money manager Mark Rowland. However, G. Kenneth Heebner, portfolio manager of CGM mutual funds, says Fidelity's power to push up stock prices is limited. "Sure they can do it, but once they've stopped buying, the market can just as quickly push it back down."
Whatever the case, size can have its drawbacks, too. When Fidelity managers fall in love with a stock, they can't buy indiscriminately. The 11 stock traders who execute orders for the managers must accumulate the huge positions Fidelity funds demand without tipping off the market and running up the stock. Says David M. Laliberte, head trader for Magellan: "Sometimes it's hard being patient when there aren't any sellers."
Of course, Fidelity is so large a manager that it can sometimes fill an order by buying stock from sister funds. George A. Vanderheiden, who runs three growth-stock funds totaling about $9 billion, had his eye on Cherry Corp., the Chicago auto parts supplier. But the shares were thinly traded, and he figured buying all he wanted on the open market might push the price too high. So he waited until another fund wanted to sell Cherry and then bought the shares through an intercompany transaction--which also saves on commissions. Fidelity won't disclose details of internal trades, but they are regularly monitored by the SEC.
For all of Fidelity's investment savvy, technological prowess, and financial clout, the Fidelity machine still depends on the willingness of investors to entrust their savings to them. So far, they've proved remarkably loyal, even when times have been tough. Money continued to pour in after the 1987 stock market crash and again during the 1990 bear market.
Fidelity's ability to continually attract new investors is sometimes attributed not to its stock-picking skills but to smart marketing. Its estimated $80 million advertising budget--the largest in the industry--has been deftly used to push the hottest funds. But in the last year especially, as the stock market has cooled, Fidelity's marketing effort has shifted, too. Now, the company is emphasizing investing for education and for retirement--and the pitch seems to be working.
LONG HAUL. Even in a prolonged market slump, Fidelity has much in its favor. Some 41% of Fidelity's $272 billion in mutual-fund assets is in 401(k) plans and other retirement accounts, up from just 28% in 1989. This steady business is growing at 33% a year, vs. 23% for the entire fund operation. Although Fidelity funds are mainly sold directly to investors by phone and investor centers, the company's Fidelity Advisor funds are now sold by banks, brokerage firms, and financial planners. Investors who buy funds through sales forces are much less likely to move money around than those who buy directly. "Fidelity's very well-positioned for the market we have now," says fund consultant Avi Nachmany of Strategic Insight.
Peter Lynch argues that Fidelity's growth potential remains enormous, even if its funds do run into some heavy weather occasionally. History shows that the longer your investment horizon, the more compelling is the case for owning stocks. As long as that continues to be true, Fidelity's wondrous stock-picking machine seems likely to approach the long-elusive goal of perpetual motion.
TOP OF THE HEAP Fund group Cumulative average total return* 10-year 5-year 3-year 1-year FIDELITY 407.7% 89.2% 50.6% 7.7% TWENTIETH CENTURY 375.7 83.5 40.4 2.2 PUTNAM 308.1 73.1 44.3 5.9 AMERICAN 300.0 63.0 40.3 6.0 IDS 276.8 70.4 37.6 4.8 FRANKLIN/TEMPLETON 255.4 57.0 37.8 9.2 T. ROWE PRICE 244.5 63.7 46.4 8.7 VANGUARD 243.3 56.9 36.9 5.9 MERRILL LYNCH 234.0 52.9 37.8 6.1 DEAN WITTER 214.7 54.2 27.7 0.5 Largest equity fund managers. Averages are U.S. diversified funds; exclude index funds *Appreciation plus reinvestment of dividends and capital gains DATA: MORNINGSTAR INC.FIDELITY'S BEST PERFORMERS U.S. diversified equity funds Average annual total return* with 10-year records 10-year 5-year 3-year 1-year FIDELITY CONTRAFUND 19.0% 18.7% 15.8% 1.7% FIDELITY MAGELLAN 18.7 13.0 13.3 2.5 FIDELITY DESTINY I 18.2 15.7 17.9 15.9 FIDELITY GROWTH COMPANY 17.0 14.9 10.7 4.9 FIDELITY RETIREMENT GROWTH 16.2 13.6 17.5 10.2 FIDELITY PURITAN 15.0 11.3 15.6 8.7 FIDELITY 14.3 9.7 11.0 8.4 FIDELITY TREND 14.2 10.2 14.1 3.3 FIDELITY VALUE 14.2 11.4 18.7 16.0 FIDELITY EQUITY-INCOME 14.0 9.4 15.1 8.5 U.S. DIVERSIFIED EQUITY FUNDS 12.8 9.4 10.3 4.4 STANDARD & POOR'S 500 14.9 9.6 9.5 5.5 * Appreciation plus reinvestment of dividends and capital gains, ended Aug. 31, 1994 DATA: MORNINGSTAR INC.