With the COVID-19 pandemic largely fading to the background and consumers’ purchasing behavior returning to normal, the market has penalized certain high-quality companies facing an inevitable earnings decline, creating compelling investment ideas among small-cap stocks, according to Fidelity Portfolio Manager Gabriela Kelleher.
“Just as the market may have been overly optimistic before, I now believe the pendulum has swung too far in the opposite direction when it comes to certain firms’ prospects,” says Kelleher, who manages Fidelity® Small Cap Value Fund (FCPVX). “And that discrepancy is an investment opportunity waiting to be seized.”
As manager of the fund since 2021, Kelleher first and foremost seeks to add value by avoiding paying too much for a stock in the first place. This is reflected in her preference for shares of firms with a sufficient margin of safety, meaning that, even if conditions fail to materialize according to plan, the securities’ downside is likely less than that of the benchmark, on average.
Kelleher recalls that stocks of certain high-quality companies skyrocketed early in the pandemic, buoyed by strong, but ultimately unsustainable, demand. Recently, however, some of these “over-earners” have experienced several quarters of weak profits, seemingly scaring investors. Nonetheless, she sees near- to medium-term opportunity in these stocks.
“To identify these former over-earners,” Kelleher explains, “I think back to 2019 and ignore the impact of the pandemic to determine what these businesses’ earnings-growth rate would look like in a ‘normal’ economic environment. Viewed through this lens, I’ve found multiple stocks trading at what I consider a particularly compelling valuation relative to quality.”
As an example, she cites Brunswick (BC), a maker of boats and boat engines. The company – a top holding at the end of May – has transformed its business over the past several years and reduced its revenue from new boat sales from about 40% to 15% of its top line.
This is crucial, she points out, because boat engines are smaller-ticket items often purchased on an after-market basis, giving the firm a more consistent income stream.
“That said, I think investors still associate Brunswick with new boat sales, and value its stock accordingly,” Kelleher highlights. “But it’s a much smaller part of the business than it used to be, and I think the stock should command a higher valuation than the market is willing to give it.”
Furthermore, she notes that multiple competitors have been forced out of the industry, enabling Brunswick to expand its market share. In addition, boats and their engines are high-margin products, which in turn generate a lot of free cash flow and afford management the ability to create shareholder value through share repurchases.
Kelleher points to another holding (as of May 31) that speaks to this theme in Hayward (HAYW), a manufacturer of swimming pool equipment and accessories that saw a surge in demand during the pandemic, as people spent more time at home and outdoors.
For a long time, investors were acting as if Hayward’s robust earnings would last forever, she says. But only so many swimming pools can be built, meaning the demand-driven momentum simply wasn’t sustainable longer term.
That said, an uptick in pools being installed the last few years should drive a steadier stream of revenue for equipment, filters and pumps, benefiting Hayward in the long term.
“While I don’t know exactly when we’ll start to see the tide turn for these and other former over-earners, for now I’m excited about the opportunity to own some of these high-quality businesses, which usually trade at a much higher valuation,” Kelleher concludes.
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Gabriela Kelleher is a portfolio manager in the Equity division at Fidelity Investments.
In this role, Ms. Kelleher co-manages Fidelity and Fidelity Advisor Small Cap Value Fund.
Previously she was responsible for in-depth fundamental research and analysis across the small cap technology sector.
Prior to joining Fidelity in 2018, Ms. Kelleher was a senior equity analyst and vice president at Goldman Sachs, where she held various investment research roles. Most recently, she was responsible for industrials and consumer discretionary sector coverage across several small and small-mid capitalization strategies in asset management. She has been in the financial industry since 2007
Ms. Kelleher earned her bachelor of science degree in finance and CPA accounting from New York University’s Stern School of Business. She is also a CFA® charterholder.