Coping With a Tough Market

When we interviewed Will Danoff three years ago, the gregarious manager of Fidelity Contrafund was in the midst of a terrific year. His fund earned 16% in 2005, beating Standard & Poor's 500-stock index by 11 percentage points -- not too shabby for a fund with $60 billion in assets. Contra made money the next two years, trailing the market by four points in 2006 and clocking it by 14 in '07. But Contra, now swollen to $71 billion and closed to new investors, has been unable to escape the bear's claws. Year-to-date to August 11, the fund lost 12%, lagging the market by almost two percentage points. "Clearly, this has not been a good year for shareholders of Contrafund," says Danoff, 48.

His long-term record remains solid. Since Danoff began running Contra in 1990, it has gained an annualized 15%. That tops the S&P 500 by an average of four percentage points per year and the average large-company growth fund by about five points per year.

Danoff excels at sizing up the big picture on the one hand, talking up company executives on the other, and using these inputs to fashion an investment plan. On this warm summer day, he arrives for an interview at a Fidelity office adjacent to Boston's South Station carrying a weathered notebook that contains handwritten stock symbols neatly placed in rows and columns. The symbols represent all of the companies whose executives Danoff has met during his 18-year tenure at Contra. To learn more about some of these encounters and how Danoff is navigating the treacherous bear market, read on.

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KIPLINGER'S: How do you manage Contrafund in this kind of market?

DANOFF: The big picture is that the housing crisis is slowing the economy. That applies to the U.S., the rest of the developed world and to emerging markets. Demand is slowing, and costs are rising. You know that profit growth is going to slow for many companies, so in that environment, whom do you want to bet with? Do you want to bet on the number-four or -five player in an industry, or do you want to bet on the market leader, which has a sustainable competitive advantage?

The way you put it, the answer is self-evident.

Right. I'm trying to upgrade the quality of my portfolio every day. And right now, one of my main themes is big, multinational blue chips. A weak dollar helps the multinationals. Continued growth in emerging markets helps the multinationals. They tend to have very good business models and generate a tremendous amount of free cash flow. And they're under-owned, probably by institutions and certainly by hedge funds. Meanwhile, their share prices have bounced around the past eight or nine years, while their earnings have grown steadily at 10%, 12%, 14% a year. I'm thinking of companies like Coca-Cola, Procter & Gamble, PepsiCo. Their price-earnings ratios are half where they were at the start of the decade. In a tough environment, these types of companies often have better outlooks relative to other companies.

Your interest in multinationals suggests you doubt "the greatest global boom of all time" will end anytime soon.

Correct. But the U.S. consumer is facing the day of reckoning. If you're a U.S. worker who's making a product that isn't competitive, you can't expect to have two SUVs and a big house and a great pension. That world is ending. The U.S. standard of living is probably going to decline relative to the rest of the world. And the U.S. dollar will continue to weaken. But that's not so bad, because U.S. manufacturers are now very competitive. And the developing economies are going to want U.S.-made stuff, such as Nike sneakers and western foods and Coke.

You haven't increased the fund's cash position much -- cash is just 7.5% of assets.

I've always run relatively fully invested. Cash never goes above 10%. If it gets that high, I say to myself that I'm not hustling hard enough. For instance, I should have been much more aggressive in buying health-care stocks this year.

Why?

If the economy is weak, you can still make a case for innovative med-tech companies and innovative biotech companies. Of course, people are worried that if Obama wins the election, there will be more controls on medical care. But as people around the world get more and more wealthy there will be greater demand for health-care services. And the demographics here and in other developed countries suggest that people will need more and more pharmaceuticals, so that's an area with big opportunities. This isn't so much a sector call as an expectation that this area will attract a lot of innovative com-panies. Genentech has been an example of a world-class, innovative company in this sector. However, it recently became the target of an acquisition by Roche, which wants to buy the part of the company it doesn't already own.

Contrafund is light on financial stocks. Have you been tempted to load up on this battered sector?

Early in my career, some of the great investors here at Fidelity helped me see the importance of earnings, and that is something that has not changed. I believe very strongly that stocks go up because a company's earnings go up. So I have a very simple approach. I ask, "Is the story improving?" And you can define that in many ways, but usually it's, "Which way are the earnings going?" In the case of the financials, the earnings estimates have been going down and so I, luckily, have mostly stayed away in the past 18 months. My experience is that after a sector has performed so poorly, there's a significant period of time before it begins a sustained recovery. I'm not convinced that we're going to see a multiyear period of outperformance by the financial stocks.

But you do own some financial stocks.

What I have tried to do is to upgrade, to find the best companies in that broken sector. So when I look at buying financials, I start with Wells Fargo and JPMorgan Chase. Wells Fargo has had some issues. It's had a lot of home-equity loans. But it's also had a strong balance sheet and a very strong management team. JPMorgan has the First USA credit-card franchise. That's been a good business, but you're probably going to see a lot more credit deterioration. Chase's Jamie Dimon has been a very good CEO. But look, there are at least 2,000 banks in the U.S. I would like to see significant consolidation.

You've been overweight in energy stocks. When we spoke with you three years ago, you said we were in the fifth inning of the energy boom. Where are we now?

The short answer is, I don't know. As the price of oil went to $145 a barrel, you could sense that there was euphoria. You started to see more merger activity, and you started to see some of the weaker players go into the capital markets to raise money. That kind of activity is usually going to lead to more supply, and that usually results in prices going down. But it's getting harder to find oil. ExxonMobil, one of the biggest oil companies in the world, has been having trouble replacing its reserves. As far as demand goes, the incremental consumer is in China and India. Wealth is increasing in those countries, and the people there want to own cars. And damn it, they have a right to own cars. So we may be entering into a period where oil bounces around from $100 to $120 and the stocks bounce around before there's another lift-off.

You have a large stake in Petrobras, the Brazilian oil company. What do you find so appealing about it?

In the resources area, I have learned that you want to focus on the assets. Management has been good, but it's the quality of the reserves that really matters. Petrobras has found some big reserves.

Does the order of your biggest holdings reflect your enthusiasm for the stocks? For example, Google is your biggest position.

The stock has been a big disappointment in the past couple of years. Google started hiring people like it was going out of style. And then all of a sudden, the company's growth went from 80% a year to 50%, so expenses started to grow faster than revenues, which meant profit margins were under pressure. And, yes, some advertisers are not advertising as much now. But the business model has been tremendous and Google has been very profitable. Where else could I have found 30%-plus growth with significant free-cash-flow generation and a stock that's trading at 20 times estimated 2009 earnings?

You own $2 billion worth of Apple. There are a lot of questions about Steve Jobs's health.

It's a concern. The guy is probably one of the world's ten greatest entrepreneurs. I'm assuming that if there were a real issue about his health, Apple would make an announcement. All I can tell you is that he started Apple, then he created Pixar and now he's back at Apple, where he created the iPod and the iPhone. When Apple introduced the iPhone, my main insight was that this meant that millions of people would go to Apple stores to look at the iPhone and then they'd look at Macintosh computers and that Apple's market share of computers would go up. It did.

Apple has certainly helped Contra's results.

If Apple thrived for the next five years, that would make my life easy. I need more companies for the fund that will do as well as Apple and Google have -- great, innovative companies with bright futures.

What excites you amoung stocks that aren't among your top holdings?

One is Activision Blizzard, which was formed by combining Activision with Vivendi's interactive-game business. This was a very shrewd deal engineered by Bobby Kotick, the CEO of Activision. He basically traded into the "World of Warcraft," a massive, multiplayer, online role-playing game. There are something like 12 million people playing 15 hours a week and paying $10 or $12 a month. It's a social thing, and it's a lot less expensive than driving to a movie theater, paying for the movie and hiring a baby sitter. And Activision also has "Guitar Hero," which has become a social phenomenon. People now are getting together with their friends and playing music with a video game. I should have bet more Activision stock. My challenge is to bet bigger earlier.

You own nearly 400 Stocks. Why so many?

I like owning lots of names.

Your crosstown rival, CGM's Ken Heebner, does just fine with 25 or so.

I want to be more like Ken Heebner. He's my hero.

Really?

His performance is staggering. What he does very well is marry the discipline of owning just 25 names with the idea of wanting to be the best performer. That leads him to the very-best-performing companies. He has an incredible knack for finding the market's true leadership.

At last report, you had 28% in foreign stocks. Why so much?

I'm leveraging one of Fidelity's strengths. We have a small army of analysts, including people in London, in Tokyo, in Hong Kong. And they help me find great companies that happen to be domiciled overseas. A few years back, one of the analysts suggested that I buy Televisa. But some things didn't quite fit, so I say, "Let's call the company." It turns out someone from Televisa is coming to Boston in a few weeks, so I say, "Let's just wait and we'll see the guy face-to-face."

So I run into the meeting and I say to the guy, "Give me 30 seconds of the big picture." He says, "We're getting out of the cellular-phone business." I say, "What do you mean? Everybody loves cellular." He says, "We can't compete with Telcel." I say, "Who is Telcel?" He says Telcel has got more stores and a better network and a better brand and a lower price. I look at the analyst and say, "Why are we looking at Televisa? Let's call Telcel." P.S., Telcel is a Mexican company controlled by Carlos Slim, one of the richest men in the world. It's part of América Móvil. Everything about the company looks great, but the analyst thinks the stock is too expensive. Valuation is always the bugaboo. Everyone always wants a bargain. But you can't get great companies at bargain prices. So I start buying América Móvil and it's been almost a ten-bagger for me.

It sounds like you ignored the analyst in this case.

I work closely with the research department. It is a huge asset. The question is, how do you mine that asset? I may start by asking about the analyst's biggest company. A few years ago I was talking to the semiconductor-equipment analyst. We start with Applied Materials, the biggest company in that area. We arrange a call with AMAT. We talk with the CFO, Joe Bronson. He's a fast-talking tough guy from, I think, the Bronx. I say, "Joe, makers of memory chips are still 50% of your business. How's Micron doing? How's Samsung doing?" And he says, "Samsung is pulling away from everybody; it's crushing Micron." So what does little Will do? I toggle up a list of our Samsung holdings and I see Fidelity doesn't own a lot of the stock. I get every note a Fidelity analyst has written about Samsung over the past ten years, and I see it's not doing too badly. It's got net cash on the balance sheet, a high return on equity, and the stock trades at eight times earnings. And Joe Bronson has just said that Samsung is pulling away. So I start to buy the stock. The way I look at this job, I'm like Woody Allen. He says something like 80% of life is just showing up. So 80% of what I do is just showing up.