Steppingstones and Clues for Further Research

Morningstar downgraded Fidelity Contrafund.  Slightly.

The former is the most powerful independent mutual fund research firm and the latter is a very large fund (with a highly-respected portfolio manager) from a legendary mutual fund company.  So it got some attention.

The Morningstar article by Robby Greengold announcing the change was short and almost apologetic in tone, opening with the statement that the fund “remains excellent” and referencing the “masterful leadership of Will Danoff,” who has been the portfolio manager since 1990.

But as time has gone on, the fund has “beaten its peers and the S&P 500 by narrower margins than before and has consistently lagged the Russell 1000 Growth Index, which is a more relevant index given the fund’s performance patterns, emphasis of high-growth stocks, and investment philosophy.”  The S&P 500 is the fund’s stated benchmark.

The main concern is the sheer size of the fund; “its colossal asset base is a substantial disadvantage.”

Here’s a look at the assets and relative performance for the fund (FCNTX) from the start of Danoff’s tenure:

Interestingly, the performance versus the two indexes has been identical over that long period of time, but the patterns are much different.  Since 2009, performance has been slightly up versus the S&P and in a persistent downtrend versus the Russell.

The assets are around $125 billion, but Greengold cites a total twice that much, telling CityWire that the larger figure includes funds that Danoff manages or co-manages in a similar style.  Not mentioned is the fact that other Fidelity funds also have stakes in many of the same companies; it’s that even larger scale that comes into play if a Fidelity analyst sours on a company.  Or if other portfolio managers are piggybacking on Danoff’s decisions.  (It happens.)

As the investment industry has industrialized, scale has become a factor (as addressed in other postings, like this one).  At what point does scale impede performance?  One thing is for sure:  asset management firms are unreliable narrators in regard to their estimates of strategy capacity.

The Morningstar downgrade was from Gold to Silver (Bronze, Neutral, and Negative are the rungs below them).  As with stock analysts, those covering investment managers are most comfortable changing their opinion gradually, especially in high-profile situations.  If scale is really a problem in this case, a bigger jump down is warranted.

The downgrade might not matter much to the fund, since flows are most sensitive to Morningstar’s star ratings — which are backward-looking measures of performance — not the analyst ratings, which are intended to be forward-looking opinions about future return potential.  (Contrafund currently has three stars.)  Plus, long-term taxable investors will be wary about selling, in order to avoid paying capital gains taxes, unless the performance deteriorates or Danoff leaves.

Contrafund would make a good case study, just on the few factors mentioned above.  But due diligence needs to go well beyond that, deep into the qualitative context for those numbers.  (That’s at the core of the online course on that topic in the Academy).

One interesting question is how decision making evolves over time, in response to changes in market environments and in the risk profile of a portfolio manager due to aging, life events, and personal world view.  (Some thoughts along those lines were included in a previous posting, “Decisions with Other People’s Money.”)

What follows are some portfolio-level looks at monthly readings of some Contrafund exposures and how they have changed since the fall of 2005:

Here are the portfolio weights in three sectors; the red line in each shows Contrafund’s exposure and the other line is the S&P 500’s (note the different scales in each panel).  At the top is technology, which has become an ever-larger portion of the market basket.  You can see that there were a couple of periods of pronounced overweighting in the portfolio.

Energy has taken an opposite course in popularity, and the persistent underweighting is not surprising in this kind of fund (but would a prolonged energy crisis change that approach?).  At the bottom is the financial sector.  A huge relative bet was cut before the financial crisis — there must be a story there — with only modest cycles of movement around the market weight since then.

The Apple exposure is fascinating.  The top panel shows the incredible run the stock has had, swamping the returns on the S&P and, to a lesser extent, other big tech stocks.  The red line in the middle shows the huge bet the fund had during the stock’s big move from 2009 to 2012.  Then the stock was market weighted for several years before becoming a persistent underweight during the latest upswing.

The problem with a chart with just portfolio weights is you can’t tell what came from the movement of the market and what resulted from the decision of the portfolio manager.  That is clear in the bottom panel.  The gargantuan position was sold down with regularity, until going flat for the last few years.  Price/earnings ratios can be tough to compare, especially when there are a lot of cyclical stocks involved — or ones that don’t ever have any earnings — but that’s not a huge problem here.  The top panel shows that Contrafund has been consistently above the S&P in terms of P/E (these are quarterly observations).  The ratio of the two is at the bottom.  There has been a fairly large contraction of late.

These kinds of charts are best used not to come to conclusions but as the impetus for forming good questions for further research.  They aren’t presented here to put forward any point other than that longitudinal information can provide important steppingstones for the analytical process — and good visualizations often reveal clues otherwise buried in a pile of numbers.