T A L K I N G P O I N T F U N D I N S I G H T F R O M F I D E L I T Y

F I D E L I T Y F U N D S - G L O B A L F I N A N C I A L S E R V I C E S F U N D

A CONTRARIAN, QUALITY APPROACH TO FINANCIALS

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Financial stocks have rallied strongly as equity markets have recovered in the last few months. However, the rally has rewarded lower quality, higher risk stocks, with many of the best performing stocks being the worst companies that fell hardest during the credit crisis.

This has provided a challenging environment for FF-Global Financial Services Fund, managed by Tal Eloya. Despite this setback to short-term relative performance, Tal remains confident in his investment process, which is designed to identify high-quality companies that will be the long-term winners in financial services.

HOW HAS THE WORLD CHANGED SINCE THE FINANCIAL CRISIS?

On balance, the answer is, probably not enough. The banking industry has experienced a near-death crisis, but western governments, regulators and, most notably, the banks themselves show little sign of changing entrenched behaviours and taking some of the more painful actions required. Despite the fact that the credit crisis was precipitated by spiralling debt, the solution to the problem has been unequivocally to increase debt.

At the macro level, we have seen unprecedented monetary and fiscal stimulus. Real rates are now negative in many major economies, while budget deficits and government debts are sky rocketing. We are driving economic growth, but we are doing it by taking on more debt, stimulating public spending and investment via negative real interest rates.

HAS ANYTHING CHANGED AT THE SECTOR LEVEL?

Most banks in the developed world still do not have enough capital. Governments had two choices: to either nationalise them outright or to recapitalise them over them a longer period. They chose the latter option, using a variety of measures.

The authorities provided free funding to cover the main costs involved in running a bank. There are several banks that would go bust if they had to fund themselves at market rates. Another important measure was the relaxation of capital rules so that banks did not have to meet capital adequacy levels.

Accounting rules were also changed so that banks can now value assets as they wish, especially the illiquid portion. This has allowed them to suggest they have sufficient capital by revaluing assets. In certain European countries, to boost confidence in the banking system, authorities also relaxed the rules pertaining to the recognition of non-performing loans.

Central banks have essentially encouraged banks to take interest rate risk by reducing rates to extremely low levels. They borrow at zero and invest in longer-duration government bonds. This is a very dangerous game because, if rates change against them, certain banks could lose a significant amount of their capital. What multiple should an investor put on these profits given the downside risk?

Lastly, governments have provided guarantees on banks’ bad assets, essentially by taking more debt and risk on themselves, making sovereign default a less unlikely possibility in countries where bank assets are larger than GDP, such as the UK and Switzerland.

As a result of all these actions, the good news is that credit markets are almost back to normal, credit spreads have tightened significantly, banks have been building capital through profits and stock markets are open again for banks to raise capital. However, it is clear that structural challenges remain.

Tal Eloya joined Fidelity as an equity analyst in August 2003. In February 2008, he assumed portfolio management responsibility for Fidelity Funds -Global Financial Services Fund. He began his career with Fidelity covering European industrial stocks and then, in September 2005, picked up coverage of European pharmaceuticals.

Prior to Fidelity, Tal was an equity analyst at Merrill Lynch.

Tal holds a BA in Economics from Tel-Aviv University, an LLB from the same university and an MBA from the University of Chicago.

FUND

PERFORMANCE as at 31.08.09

-35

-30

-25

-20

-15

-10

-5

0

5

10

15

20

3 months 1 year 3 years

Ret

urn

(%)

Fund

Benchmark

Quartile 4th 2nd 1st

Source: Morningstar, NAV-NAV, gross income reinvested excluding initial charge in EUR.

Benchmark: MSCI AC World Financials Index

COULD YOU TALK ABOUT THE RECENT CHALLENGES TO FUND PERFORMANCE?

The fund has underperformed recently, mainly because lower-quality, higher-risk names have led the rally. These are, for the most part, exactly the same stocks that I avoided in 2008, to the benefit of the fund. I remain confident in my investment process, which has delivered good relative performance since I took over the fund.

To explain why the fund has underperformed its benchmark recently, it is important to frame this within the context of my ground rules for investing:

I only buy stocks that I understand and where there is a solid investment thesis. Balance sheet strength is key and I spend a lot of my time going through the figures myself before investing in a stock. I must say that I struggle to pinpoint what, apart from improved investor sentiment, has been supporting some of the stocks that have performed so strongly of late.

T A L K I N G P O I N T F U N D I N S I G H T F R O M F I D E L I T Y

I take a two-to-three year investment view. By doing this, I try to take advantage of the short-termist approach typical of most investors, by buying quality companies when they fall out of favour.

I stick to my investment thesis, regardless of stock price movements.

The last two years have seen levels of equity market volatility as extreme as they get and, despite this challenging backdrop, the fund held up considerably better than the sector. We avoided all the blow-ups including Bear Stearns, Lehman, Citigroup, HBOS, Royal Bank of Scotland, Barclays, Fortis, Washington Mutual, Wachovia, AIG, Fannie Mae, and Freddie Mac. This demonstrates that the investment approach works. The fact that the fund was significantly underweight the western developed banks ,was a key driver of outperformance in 2008. Despite the fact the outlook for many of these stocks remains poor, rising investor sentiment has allowed them to bounce off their lows.

My approach is built on owning high-quality firms that prosper regardless of macro conditions. I do not speculate with my investors’ money. I am not willing to trade out of high-quality companies to invest in poorer-quality, more speculative, companies because they happen to be outperforming for a period. I am willing to be patient and want to adhere to my investment principles. Clearly, this fundamental approach, focused on valuations and quality, can occasionally hurt relative performance but, over the long term, it has proven itself time and again.

TOP TEN OVERWEIGHTS (%) as at 31.08.09 Fund Benchmark

DEUTSCHE BOERSE 6.4 0.3

MIZRAHI TEFAHOT BANK 4.2 0.0

FRANKLIN RESOURCES 4.5 0.3

ACE 4.2 0.4

PNC BANK 3.5 0.4 AFRICAN BANK INVESTMENTS 3.0 0.1

PITNEY-BOWES 2.9 0.0 ITAU UNIBANCO BANCO MULTIPLO 3.5 0.7

BANCO BRADESCO 3.3 0.5

ICAP 2.4 0.1 Source: Fidelity

Benchmark: MSCI AC World Financials Index

WHAT IS YOUR OUTLOOK FOR FINANCIALS AND HOW ARE YOU POSITIONING THE FUND?

The outlook varies significantly between different parts of the global financial services universe.

Developed world banks. Essentially little has changed in the western banking model; we have postponed the problems as opposed to solving them. And, unfortunately, the longer it takes to fix the problems, the more likely we will follow the path of Japan.

As I mentioned, we are trying to solve a debt problem by taking on more debt. One of the root causes of this crisis was the sustained availability of very cheap money and, despite that, policymakers have chosen to delay the pain by easing monetary policy again. As a result, in most developed countries around the world, there are no more cards to play in case this recovery is not sustained. Real rates are already negative and public debt is already at very high levels. What can they do next?

Moreover, governments are providing free funding to banks that are not going concerns; essentially, keeping zombie banks alive, just like they did in Japan. This is the case with a lot of the Scandinavian banks, KBC in Belgium and others. Certain banks do not have to recognise non-performing loans, meaning the bad assets remain on the books, and the banks are reluctant to lend.

On top of that, regulation has to change, which will probably have the effect of making the western banks more like utilities. They will produce a more moderate, but stable, return on equity (ROE) since markets are fully penetrated and GDP growth is low. How much should investors pay for businesses that, in the best case scenario, will make much more moderate, stable ROE’s than they did and where there is still considerable downside risk?

Having said all that, the main opportunity, which is yet to play out in the developed world, are significant market share changes. In the current environment, winners such as HSBC, Wells Fargo and Intesa are at a disadvantage since governments are keeping alive so many bad banks. Once we return to a more normal world, these banks will take significant market share. While I am underweight developed world banks, I own more of the US banks and less of the Europeans and I own the market share winners.

Emerging market banks. This is the big opportunity in the global financial sector. I think the case for these stocks is compelling on a long-term view. Indeed, this is one of the main reasons investors should buy this fund, as banks grow at multiples of GDP. However, one must be very selective.

I think banks in India, Brazil, Peru, Egypt, China, Indonesia, and Turkey will re-rate going forward as markets realise that sustained growth potential in emerging markets is considerably higher than it is in developed markets.

All these countries have in common solid banking systems, with strong banks, huge penetration potential, low debt levels, and a lot of savings. At present, I have a big overweight in Latin America, mainly Brazil and Peru. I selectively own banks in India. In Asia, valuations are not attractive but I am prepared to wait for entry points.

Asset managers and stock exchanges. I continue to like this part of the financial sector, partially as a hedge against my underweight in banks. Firms in this sub-sector have a number of advantages: they tend to be more transparent businesses where numbers are not manipulated; there is limited leverage; they have good recurring cash flows; there is scope for high and sustainable returns; there is less regulatory risk; and there is less likelihood of dilution risk, with shares also available at reasonable prices.

In the case of asset managers, we could also see some firms benefit from the crisis due to consolidation. Asset managers have also taken a lot of cost out of their businesses, so operating leverage has improved. I also favour investment in stock exchanges, especially the ones that are very likely to benefit from regulatory changes and debt issuances, such as Deutsche Boerse and CME.

T A L K I N G P O I N T F U N D I N S I G H T F R O M F I D E L I T Y

Investment banks. I am neutral towards this part of the market as visibility is still very low. I prefer to own the best in class, which is Goldman Sachs. The industry still has significant structural issues, but on the other hand, there is a lot of market share potential, so I aim to own the market share winners and those that have a global reach.

Insurance. I continue to favour the reinsurance groups as pricing is gradually improving, balance sheets are in good shape and the industry is benefiting from consolidation.

On the other hand, I see little value in the life insurance industry, where the downside risks are similar to the developed world banks. If longer term interest rates keep falling, the business model of these firms begins to run into structural problems. They essentially guarantee a 2-3% rate, but if long rates are 3% or below, I cannot see how they can make any profits.

“Investors in financials can occasionally be guilty of buying into stocks with incredibly complex balance sheets which they do not fully understand. In my view, there is, in fact, very little margin of safety in many of these stocks. Some bubbles have burst over the last two years, while others are yet to burst. I remain patient and will wait for my opportunities to deliver long-term value.”

Tal Eloya, Portfolio Manager