Saturday, November 24, 2007

Fidelity Recovery Strategy - 1998


Fidelity is mounting a comeback after its crisis in 1995 and 1996.

Behind Fidelity's attempt at renewal is a complete overhaul of the mutual-fund operation and an even broader restructuring of the entire Fidelity empire. Those changes include a brand-new national TV and print advertising campaign featuring former Magellan manager Peter Lynch and comic Lily Tomlin. In a sharp break from past campaigns, this one doesn't push particular products but rather encourages people to seek advice at Fidelity. Later this fall, Fidelity will roll out new brokerage services aimed at making up ground lost to the growing number of financial industry giants targeting Fidelity's turf.

Orchestrating Fidelity's makeover is James C. Curvey, an unlikely character to lead Fidelity back to health (page 188). Until early last year, Curvey, 63, was president of Fidelity's venture-capital company, watching over a car service, a newspaper chain. He was a member of the parent company's nine-man operating committee.

On May 1, 1997--Johnson named Curvey chief operating officer, giving him sweeping power over operations. Hondros, Chief of Marketing of mutual funds resigned a few months later. Sixteen months later, on Sept. 3, 1998, Johnson gave Curvey the added title of president, solidifying his authority as Johnson's right-hand man.

Curvey is radically shaking up Fidelity's corporate culture, trying to repair divisive, behind-the-scenes management problems that contributed to the 1995-96 crisis. He has totally realigned Fidelity's senior ranks and restructured virtually all of its operations aimed at selling products to individual investors, brokers, registered investment advisers, and banks.

Central to Curvey's approach has been to sharply rein in the decentralized, entrepreneurial culture that served Fidelity so well when it was small. Power, once spread among 12 senior managers reporting to Johnson, has been consolidated among five managers. All the top players now have 20% of their bonuses tied to their success in cooperating with one another.

This seemingly innocuous new compensation system is a dramatic step for Fidelity. In the old Fidelity, conflicting goals and competition among top executives led to numerous problems, including redundant technology development and marketing efforts and turf battles over customers. ''Suspicion and mistrust among different units'' was one factor behind the slow development of a Windows-based software program for retail brokerage customers called Fox On-Line Xpress, says Mark A. Peterson, president of Fidelity's computer operations. The three-year delay in developing Fox, followed by a shorter delay in launching stock trading on the Internet, allowed competitors, such as Charles Schwab & Co. to surge ahead in electronic brokerage. Curvey ''has forced us to really rethink the way we did things here,'' says Abigail P. Johnson, daughter of Ned Johnson and a senior vice-president.

Burkhead's (head of mutual funds replacement is Fidelity's longtime general counsel, Robert C. Pozen, a government affairs specialist who declined an offer to become President Clinton's lead Far East trade negotiator when he signed on to his new job.

Since taking over in April, 1997, Pozen has restored order among Fidelity's force of 326 fund managers and analysts. No high-ranking equity managers have left Fidelity since. A key tool for doing this: money. Fidelity managers were hardly underpaid before, but in 1997 and 1998, Fidelity granted millions of dollars in stock of the privately held company to key fund managers, all deferred as an incentive to stay.

Size had become a handicap. Many Fidelity funds had grown so large they could no longer nimbly maneuver through the market as they had in the past. The size problem, many worried, made them less likely to ever again produce the spectacular returns they achieved when they were smaller. In 1993, for example, 19 out of 20 Fidelity growth funds beat the Standard & Poor's 500-stock index, many by a margin of more than 2 to 1.

That incredible performance led investors to pour money into Fidelity at unprecedented rates. Faced with billions of dollars in new cash, many fund managers in 1994 began sidestepping Fidelity's traditional approach of investing in a diversified array of hundreds of fast-growing small and midsize companies in favor of making big bets on whole sectors of the economy, such as technology stocks or government bonds. Some funds strayed wildly from the objectives described in their prospectuses. The Blue Chip Growth fund, for example, invested heavily in unknown small-cap stocks.

Even worse, performance was hurting Fidelity's reputation with companies that offer mutual funds in their 401(k) plans. It began losing new business to such rivals as Putnam Investments, which at the time had better returns.

Soon after taking charge, he closed Fidelity's four biggest funds to new retail investors: Magellan, Contrafund, Low-Priced Stock, and Growth & Income.

A number of smaller fixes are also helping. Pozen cut the workload of some managers and appointed apprentice managers for some smaller funds. Fidelity's 248 analysts have been divided between small-cap and large-cap stocks and seven specific industry sectors. Analysts now cover only 35 companies instead of 68 and spend two years specializing in an area instead of one.

HONING DATA. Other changes, as well, are helping the funds gain against rivals. One is a new stock-picking approach that is changing the way Fidelity invests. Under the old system, devised by Lynch, Fidelity focused on buying companies with strong earnings growth that were likely to beat Wall Street earnings estimates, and it traded aggressively in and out of these mostly small- and mid-cap stocks.

Now, Fidelity is less concerned with beating the Street's earnings estimates and is focusing more on companies with consistent earnings growth. ''We came to grips with the idea that even if the price is rich, if the earnings are good, you can still have good appreciation,'' Pozen says.

This has led many Fidelity funds into large stocks, such as Coca-Cola and Microsoft, that have high price-earnings multiples. Now, says Dividend Growth Fund manager Mangum, ''I'm much more willing to take multiple risk than earnings risk,'' in part because the fast-growing, smaller companies Fidelity used to favor tend to get pummeled by investors if they have even slight earnings problems.

Another reason for the movement into large-cap stocks is a new, broad set of quantitative data designed to identify investments that drag down the fund's performance. Quarterly financial reports pick apart fund holdings and strategy. The data includes comparisons of each fund's industry sector weightings with those of competing non-Fidelity funds and analyses of what would happen if the fund doubled its bets on its 20 largest holdings.

The most valuable information, Pozen says, identifies holdings that are underweighted relative to a fund's benchmark. If a fund whose bogey is the Standard & Poor's 500-stock index has 1% of its money in Intel Corp., it's a negative bet, since Intel constitutes 1.6% of the index. The fund will suffer against its benchmark if Intel does well.

The system prods managers into paying more attention to their smaller holdings, which often get short shrift in a large portfolio. The idea is that if a manager likes the stock, he or she should consider increasing the position. Conversely, those positions that are underweighted because the manager has cooled on the company may be targets for sale. Fund manager Mangum says this analysis has helped him run his $7 billion fund by eliminating smaller positions, which take time to monitor but have little impact on returns. ''If I can't own at least 1% of a company, why bother?'' he says. So he has used the quarterly reports to help him trim his portfolio down to 123 stocks, from 250. Many of his top holdings are now also heavily overweighted compared with the weighting they get in the S&P 500, Mangum says.

Fidelity has another analytical tool that can help improve performance. Funds that trade aggressively have high trading costs, which can hurt returns. So, Fidelity now produces a separate report monthly showing how much a fund might save if it reduced its trading. Not all managers use it--Mangum, for one, says smart stock-picking should more than overcome the increased cost of trading. But many Fidelity funds are trading noticeably less than before. Magellan, for example, turned over its portfolio about once every ten months in 1995, but now it's nearly once every three years.
The jury is still out on whether Fidelity's revamped stock-picking machine will bring back its halcyon days when many funds routinely beat the market. The new analytical tools may not help the behemoth funds very much if the market starts to favor small- and mid-cap stocks.

Some Fidelity watchers, including several former Fidelity fund managers, argue that some larger funds now look more like index funds. Eric Kobren, publisher of Fidelity Insight, calculates that some large funds, such as Growth & Income, have a 98% correlation with the S&P 500 over the past three years. One former manager says: ''All these guys are getting paid to do is tweak indexes.'' Says another: ''It's a form of indexing...a certain amount of S&P stocks need to be in the fund.''

Abigail Johnson, who oversees the Fidelity growth funds, dismisses that claim. ''That's not supportable if you look at the data.'' Fewer than half of Magellan's holdings were in the S&P 500 earlier this summer. Pozen notes that most funds are invested in a wide variety of holdings beyond the S&P 500. For example, as of June 30, only 118 of Contrafund's 336 stocks were S&P 500 issues.

Fidelity's turnaround is a work in progress. Company officials have said little publicly about the changes until now, believing they were not complete. But Curvey says the company should acknowledge its past mistakes and move on: ''We're almost a public trust here...and we have an obligation to tell people what the hell is going on.''

In 1995, Fidelity collected nearly one-third of new money flowing into mutual funds. But through the first half of 1998, Fidelity's market share stood at just 7.3%

Of course, there's more to this company than mutual funds. One long-held goal left unchanged by Curvey is to diversify the business and make the company's fortunes less dependent on mutual funds. Fidelity now sells dozens of products--both financial and nonfinancial--developed by more than 40 separate companies. The offerings range from stock trading to bond underwriting to insurance and back-office support for brokers, independent investment advisers, and corporate-benefits departments.

Johnson built these businesses by exploiting the advantages of being privately held. He incubated each one from scratch--sometimes doubling up efforts to create competition. Many he funded for years, even if they lost money. Several Fidelity sources say its retail brokerage unit hasn't made a dime in years. Fidelity declines to comment. Many of these units were run by high-ranking execs with their own budgets and total autonomy--and responsibility--to organize and market their products as they wished.

Curvey says this system broke down as Fidelity's growth soared. Before he become COO, Fidelity had 17 internal newspapers and five nearly identical software programs under development for five different parts of the company. Hundreds of millions of dollars in marketing and promotions were being spent on duplicate or competing projects.

Fidelity has been acclaimed for its technological expertise, but that has come at an enormous price. In one oft-cited case by former employees, Fidelity spent hundreds of millions of dollars over seven years developing competing data processing systems to handle customer accounts. Finally last year, one project, called Vantage 20/20, was scrapped despite an investment some former employees estimate at $500 million. Curvey won't confirm that figure, but he says not all of the money spent on Vantage was wasted, since parts of the project have been adopted in other company systems.

Curvey has started cleaning up the mess. He's consolidated Fidelity's computer operations under one executive, Mark A. Peterson, who has built a new computer center in New Hampshire to handle online transactions, which now amount to 60% of brokerage trades. Curvey also named Burkhead to oversee all brokerage and marketing operations, consolidating 11 units. Curvey has also assigned each operating committee member cross-company projects to force them to work together. And he bases part of their bonuses on how well they develop successors. ''None of what I'm doing is rocket science, but we've never had any of this before,'' says Curvey.

Johnson at 68, is preparing for retirement, though he refuses even to hint at when that might come. He ran Fidelity without a second-in-command for 12 years, but he now is trying to build a management team capable of running Fidelity when he steps down. Although Curvey has been the mover behind Fidelity's shakeup, he will not necessarily succeed Johnson. Johnson says he will decide on his successor when he retires, based on ''who's available at the time and what skills the company needs.''

His first choice is Abigail, 36. A former fund manager, she joined the executive ranks last year to help oversee funds and broaden her experience dealing with other parts of the company, including the marketing, public relations, and legal departments. She owns 24.5% of Fidelity's voting stock, potentially worth $4 billion to $5 billion if Fidelity went public, according to industry estimates. Her father owns 12%, and other Johnson family members own an additional 13%.

Abigail is the beneficiary of a trust that grants her ownership of Fidelity ''for her lifetime'' and could keep ownership in the family for another generation as well, her father says. Two years ago, he gave 51% of the company's voting stock to 50 top employees, as a way to reduce estate taxes. Since then, many employees have hoped that Fidelity will go public, producing windfall profits. Fidelity may be worth $20 billion in an initial public offering, some estimate.

The trust allows Abigail to sell Fidelity or take it public. But Johnson says he does not want that to happen. ''I'm not really going to reach out of the grave and curse her if she does that,'' Johnson quips. But, he adds, ''there wouldn't be any strong financial incentive at all'' for her to do so. ''If there were good business reasons, maybe it would happen,'' Johnson adds. Abigail says she wants Fidelity to remain private.

Abigail has her choice of jobs, her father says. She can oversee strategy, head operations, or remain in a lesser role, he says. Abby says she will decide that when the time comes. Her father, she adds, is in excellent health and will ''probably never'' retire. He has worked out regularly with a personal trainer in his Boston home for the past 10 years, and occasionally challenges his aides to a game of tennis.

Whether Curvey and his changes go far enough to solve Fidelity's problems is still to be seen. The new marketing strategy, which emphasizes advice, is a sharp break from the past practice of promoting funds. And new brokerage products that Fidelity will roll out in coming months, including a voice-recognition trading system and a program to offer customers investment advice, are coming on the heels of similar products offered by competitors.

Fidelity is far from being the money machine it was in the early 1990s. But Curvey has stopped the bloodletting and has Fidelity back on the warpath.

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