Fidelity reveals what it takes to find tomorrow’s large caps today

James Abela is taking his eye for spotting emerging companies to global stocks. Right now 25% of the opportunities he is seeing are in tech!
David Thornton

Livewire Markets

A lot of money can be made by buying large cap stocks that have potential to grow further. Yet a lot more money can be made by investing in those companies when they're still small or mid cap stocks. 

The Fidelity Global Future Leaders Fund, which started life in September 2020, looks for just these sort of companies. The fund focuses on undervalued quality companies, but it doesn't shy away from a bit of momentum if the company bears those quality characteristics and is trading at an attractive price. 

It's a strategy that has returned 10.92% per annum since inception, beating the index by 1.41% per annum. That's impressive when you consider this is a balanced portfolio more designed to form the core of investor's portfolio. It prioritises consistent returns over the kind of volatile returns you often see in funds that play in this end of the market.  

James Abela, Fidelity International

For today's Undiscovered Funds Series Q&A, I sit down with James Abela, Co-Portfolio Manager of the Fidelity Global Future Leaders Fund alongside Maroun Younes. James discusses the three key attributes leading small and mid cap stocks will need to have to outperform through the next 12 months, the sectors with the best free cashflow yields, and his high conviction pick - a beaten down German energy stock.  

Note: This interview was filmed on May 2, 2023. 

Managed Fund
Fidelity Global Future Leaders
Global Shares

Edited Transcript

LW: What companies does the Global Future Leaders Fund invest in?

The fund is focused on global mid and small cap funds from US$2 billion right up to about US$50 billion, but the median size is about US$20 billion. It is a mid and small cap global fund, so that index is predominantly US dominated, but it includes the US, Europe and also Japan. We focus predominantly on quality companies but then also turnarounds and value stocks. So it is very much a blend of global mid and small caps in the total offering that the world has.

What role does the fund play in a portfolio and what kind of investor is it targeting?

The real target is that it's a very blended portfolio. So it's not trying to go extreme growth or extreme momentum thematics or a deep value fund. It is very much a core fund that really tries to go across a blend of quality momentum and sort of turnarounds, that means it's less like cyclical compared to the index. In the the COVID crisis when the market fell 20%, we were up sort of 5% to 6% relative. But when the market did recover and the quality has come back into the market, we've been recovering quite well as well. So we're up you know 3 or 4% relative to index for this year. So it is a core portfolio and it is quite balanced in terms of its valuation discipline, but it does have a slight growth bias.

How do you find tomorrow's large cap stocks when they're still small caps? What's the filter process?

We use a bottom up stock picking tool called VSC: 'viability', 'sustainability', 'credibility'. What you want to look for on the viability side is the return profile. Either return profile there's two real ways. Quality name have high returns and they're maintaining those high returns and turn around stories or cyclicals go from a low return to a high return. Those low return to high return stocks can be up 3 or 4. Times at 3 or 400% over a couple of years, whereas the high quality ones have high returns and they compound overtime. Call them beautiful compounders. And there's really those two profiles of stocks that you want to look for. Viability is really the first thing you look at. Sustainability is how long that lasts for. Is a structural, is it cyclical, is it a turnaround company or is it a longterm winner? And then credibility is still very important regardless of the stock. Do you trust yourself to make judgments?

Can you prove to yourself that management is good, accounts are good and the market structure is good, and those are really important things to drive your conviction levels on those two other pillars of viability and sustainability. But that's really how you try and find what you're owning and why you want it as well.

Why should investors consider global small and mid cap stocks?

Australia is narrow and shallow. There is a lot of momentum, and there are thematics and high quality stocks in Australia that are great opportunities. But it is smaller and the pool in the world is just much larger, much broader, much deeper and has greater access to thematics. It's just a much bigger opportunity set and that's really why you want to go global. Also, globally the valuation discipline is much higher compared to Australia because of that narrow and shallow market. 

Things do get overbought and there are also very under-loved companies. So it tends to be a very hot and cold to the market. Australia and more momentum driven and global is much more balanced. Quality and value dominate in terms of styles, but the valuation discipline is still very, very high because you've got.

I guess a lot more cynicism on global because people are looking at it in a whole global context in terms of competition and the fact that you're you're out there on a global basis, so you're you're not in a small market, you are against the world. So the valuation discipline tends to be higher and the momentum thematics are much lower.

What attributes will define the small and midcap companies that will lead the market over the next 12 months?

It's going to be earnings this year. The world has gone from very forgiving the last couple of years to very fearful this year. And that fear for the market is going to be focused on earnings and what I call reality bites.

So earnings, cash flows and confidence, those three things are going to be very important. If you have those three things, you're going to be trading quite well. If you don't have those things, you're going to be trading down and not keeping up with a market that is still volatile but wants to move forward. 

And I think you need to have those things in order to move forward. So I think that'll characterise the winners for this year.

You recently wrote an article on Livewire titled "Revenue is Vanity, Profit is Sanity, But Cash is King." Where are you seeing the best cash flow yields in the market right now?

Things like insurance and also technology are really actually quite strong and cash flows and globally it's a bigger set. It's some resources names, financials, definitely industrials and then also technology. So they're really they're similar definite themes, but those are the four groups where those strong cash flows are high and growing. So I think that's that is definitely quite important in this market.

Can you give us some high conviction names across those those buckets?

In consumer discretionary, we own Moncler SpA (BIT: MONC) which is a high-end luxury brand. They make $4000 jackets for the European snow season which very popular with Asia but very popular with travellers or people that ski. They're also a big status symbol. So I love these brands that define who you are. You might go and buy LVMH bag or a bottle of champagne or Montcler jacket and you actually get status by buying that item. So it defines you, which again goes against all the macro and geopolitical shifts. That's one in the consumer where there is strong cash flows and there's strong earnings.

Insurance is another one. A good example is Arthur J. Gallagher & Co. (NYSE: AJG) has strong cash flows. It has a lot of really strong sort of positive insurance cycle trends. So hardening of the cycle increase in tech reserves and shareholders funds and also they're growing because people are buying more insurance as the markets getting more concerned about the economy generally. They're getting these beautiful three-way drivers of earnings improvements. That's a really good money in financials.

In industrials, there are a lot of picks and shovels businesses like WW Grainger Inc (NYSE: GWW), which is really good. That one has been delivering really well and had a good result last week. So in those areas there are some good examples that you know are really producing good results in good cash flows right now.

What are some sectors that you're not investing in at the moment?

We are not in a lot of defence or expensive defensives I guess you call. We don't own real estate, utilities own property-related companies. They don't have high returns. They don't have real turnaround stories. They don't have structural growth available to them. They'll do it tough in a rising interest rate environment because the hurdle is going up, the cost of capital is going up. And the ability to buy stocks that are still like good value is still available outside of those expensive defensives. 

How do you reconcile what's happening in on the macro side with your fundamental analysis?

They're not that far apart. Sometimes I do feel like they're very far apart when you get big, big style shifts. The movement from quality to to value, for example, or the movement from momentum to quality or momentum to value, they're big shifts that we see. So the key thing is you go back to valuation. 

You see when you have, for example, a big quality bubble or a big quality rally. Free cash flow yields from quality stocks can go from say 3% to 1%. P/Es go from say 20-5 to say 50. And you can see that in the free cash flow yields. But then also value stocks can go from say 7% down to 5%, which means they may sometimes double. And so I think the easiest way to kind of breakthrough is to make sure you're looking at a multifaceted valuation parameter set. So look at P/E's.

Price to earnings to growth. For me, I look at P/E to ROE and you look at free cash flow yields and I think you need to look right across the board because cyclicals you won't see on the P/E's. You need to look at them on price to book and free cash flow yields and quality, you need to see that they're getting overvalued through the free cash flow yields. And I think if you have a a really strong valuation parameter set, you can match the macro and the micro with valuation mirrors. And you can see where the market's pushing too high or also pushing too low.

Are quality companies as attractive this year as they were last year?

There's definitely a split, so there are quality names that I think have run too hard. But the opportunity set is still pretty large for quality names. So in the global, you can still find quality names that are delivering 10% growth in a pretty flat market, 10 to 15% EPS growth trading on 20 to 25 P/E's and they're on free cash for yields of 2% to 3%, which is still within our parameters - that's quite attractive as a quality business and ones where the market structures are quite good. 

So market structures that are either small or they're critical. Or they are consumer kind of desired status symbols and those are the ones that you want to own I guess now and for the long term. But definitely in this market valuation sensitivity is something that you need to have top of mind.

The fund also looks for structural tailwinds. What are some of the best examples of structural tailwinds in today's market?

Structural tailwinds you can find across the board. I mean, ones I'll just focus on is is really technology. There's so many structural themes in technology, so data to the cloud, artificial intelligence like solar panels, efficiency of technology, trying to create economic efficiency or environmental efficiencies is a really, really big theme. 

But technology just as human beings and organisations and governments trying to create efficiencies in our systems like whether it's in our lives or our work lives or in the systems of society. Technology is across the board in so many different elements of that as a global thematic. And I think that's what is probably the most exciting thing for us. About a quarter of the fund is in technology.

Software processes, consulting, solar panels, that that's a whole cluster of technology that is aimed at making everything more optimal, more efficient. And that for me as we're getting costs and and cost of Labor and everything, that's going to be an ongoing structural theme. Right across for the next decade at least and more So that's why that is quite exciting for us and we're definitely, you know, hugely interested in all the technology space because it's a massive thing.

Can you give us the thesis behind a recent high conviction company that found its way into the fund?

One is Siemens Energy AG (ETR: ENR), which is an interesting one. It's a turnaround story, had a lot of negative news stories come through. So supply chain issues and earnings issues. Delays on projects etc and now that's coming out of a recovery phase and it has now been trending up as the earnings have improved, confidence has improved and the management outlook is now a lot more confident. Supply chains are better, projects are getting done. The world's in a post-COVID environment. So that's sort of a big one that I guess is more recently entered into the portfolio.

Managed Fund
Fidelity Global Future Leaders
Global Shares
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David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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