To outperform over time, says Steve MacMillan, portfolio manager of the award-winning Fidelity Small Cap America, a fund needs to look very different from the index.
MacMillan's fund, which was honoured as the best in the U.S. Small/Mid-Cap Equity category at the Morningstar Awards in 2015, certainly does. He estimates that there is only a 1% to 2% overlap between the fund's holdings and its market benchmark, the Russell 2000 Index.
MacMillan, who is with Fidelity Investments Canada in Toronto, focuses on U.S. small- and mid-cap companies with stable and recurring earnings. Among the other attributes he favours are limited technology risk, barriers to new competition and long product cycles.
According to MacMillan, he differs from managers who wake up every morning with the goal to make money. "It's an admirable goal. However, it's not mine. My goal is to not lose money." He believes that to avoid losing money, one way is to start off by buying stocks that are cheaper than the market.
He cites as an example Snap-on Inc. (SNA), a manufacturer of tools and equipment. The stock, among the fund's top-10 holdings, was trading at a very low valuation when he bought it for the fund about four years ago.
At the time, Snap-on management was confident they could grow revenue and earnings consistently and they've been able to do so, MacMillan says. "They've also been able to generate a lot of capital that they can reinvest back into the business. So it really acts as a supercharger in earnings growth, that ability to have excess capital at the same time as you're growing."
MacMillan defines his investment universe as consisting of U.S. companies with market capitalizations of about US$5 billion or less. But his mandate is flexible enough to allow him to hang on to profitable holdings that grow far beyond that threshold.
An example is the fund's recent top holding, Hanesbrands Inc. (HBI). The apparel company, which had a market cap of about US$3 billion when purchased for the fund three years ago, has roughly quadrupled in size to about US$12 billion.
Buyouts of small-cap businesses by larger companies are common, says MacMillan, especially during periods of slow economic growth. He estimates that close to 20% of the fund's holdings have been purchased in the last six months by larger companies. One such holding is Ingram Micro Inc. (IM), an information-technology wholesaler. In February, Ingram agreed to be acquired by a Chinese company at a steep takeover premium, in a transaction scheduled to close later this year.
In carrying out his qualitative and quantitative stock-selection processes, MacMillan says he can draw on the research of more than 200 Fidelity Investments analysts. As well, he estimates that he meets with executives of more than 500 companies over the course of a year. In 2015, these meetings led him to invest in six of the approximately 40 stocks that the Morningstar five-star rated fund currently holds.
MacMillan says he never makes market calls from a top-down perspective. For instance, he doesn't pay much attention to whether interest rates will rise in the United States. In his view, if interest rates are going up, it's generally a positive sign that the economy is strengthening.
Though he is a bottom-up stock picker, MacMillan does have sector biases. He avoids cyclical businesses that are capital-intensive and that lack competitive advantages. As a result, he says, the fund will never be invested heavily in energy stocks.
Similarly, the fund's holdings in financial-services companies have always been less than the sector's weight in the fund's market benchmark. In general, under MacMillan's tenure since 2011, the fund has always had large weights in technology, the consumer sector and health care. He says that will probably continue to be the case over a long period of time.
MacMillan's portfolio turnover tends to be low. It has been at buy-and-hold levels of 22% or less in the fund's four most recent fiscal years. "I'm looking in the five-year plus time horizon for a stock," he says. "In a market that's dominated by high-frequency traders, that creates an opportunity for me. If you can invest with patience, I think you can outperform over time."
The first quarter of this year has been a losing period for the U.S. Small/Midcap Equity category, with Fidelity Small Cap America's Series A sustaining a three-month loss of 4.9%, slightly worse than the median loss of 4.8%.
MacMillan's reaction to the short-term slump is that it has created more investment opportunities at attractive prices. "Today we're actually at the lowest valuations relative to large caps than we've been in my tenure of managing this fund," he says "If you look at what's going on in China, Japan and Europe, the U.S. probably has the strongest growth in the world. If you're looking for a way to get exposure to the U.S. domestic economy, I think the small/mid-cap space is really the way to do it."