Small Cap Discovery: Seeking Opportunities in the Small Cap Asset Class

Historically, the small-cap segment of the market has delivered superior returns relative to other asset classes. This stems from the inefficiencies that have persisted due to the lack of analyst coverage and the overall risk-and-reward profile of small-cap companies. History has shown that small-caps have bested the broader market coming out of a bottom in equity markets and recessions. For those investors lacking small-cap exposure or seeking the diversification benefits small-caps offer, it might be timely to begin building an allocation to small-caps in the context of a long-term view.

What are small-cap stocks and why are they important?

The range of market capitalizations for small-caps is between $10 million and $2.3 billion, according to the Russell 2000 Index, which is the standard proxy of small-caps in the U.S. For perspective, large-caps are generally in excess of $8 billion, while mid-caps are in between.

Allocating a portion of your portfolio to small-cap investments can be important for the following reasons:

• While more volatile, especially over the short term, small-caps may provide greater potential for growth and long-term capital appreciation as compared to large-cap companies.
• A benefit to the small-cap investor is that small-cap equities tend to be less efficient and present more opportunities for mispricings. This is often due to the lack of analyst coverage, the breadth of companies and at times lack of liquidity.
• Small-cap companies have the fewest Wall Street analysts covering them relative to mid and large caps. Due to this information asymmetry astute investors have the potential opportunity to uncover overlooked companies.

Historically, investing in small-caps has resulted in higher rates of return as compared to large-caps. In addition to solid long-term results, small-cap stocks also have tended to lead coming out of bear markets. Looking at the last eight bear markets since 1962, small-caps have outperformed the S&P 500 by an average of 12.26% in the 12 months and 13.90% in 24 months following the bottom of the equity markets. As shown in the chart below, small-cap stocks have delivered strong relative performance, outperforming the broader market in every cycle 12 months from the bottom, and six out of the last eight periods 24 months from the bottom. Using March 9, 2009, for the current low in equities, we can see that small-caps have outperformed the broader market. Furthermore, when looking at ten-year risk adjusted returns (i.e. return per unit of risk) small-caps have bested large-caps providing further support for the assets class in a diversified portfolio.*

Keep in mind however that this return potential is accompanied by additional risks when compared to Mid and Large capitalization companies. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.

Why you may want to consider Fidelity Small Cap Discovery Fund:

Once you've made the decision to invest a portion of your portfolio in Small-Caps, the question becomes how to go about doing it? Investing in small-cap stocks can be complicated given the limited amount of information available and the higher volatility that factors into your investment success.

That's where Fidelity's years of small-cap investing experience can help. Fidelity Small Cap Discovery can serve as a core investment option for small-cap minded investors. By leveraging Fidelity's expansive global network of research professionals and dedicated small-cap team, experienced portfolio manager Chuck Myers seeks to pick what he believes to be the best small-cap stocks within the funds investment mandate.

Small Cap Discovery is designed to provide exposure to small-cap stocks through a value oriented approach. Chuck tends to favor companies whose current share price varies widely from what he believes is a fair assessment of future value. In an attempt to manage volatility, he focuses on an investment's "margin of safety." This leads him to dedicating much of his research efforts on analyzing each company's balance sheet and overall risk-profile. Chuck favors easily understood business models and tends to avoid fast moving companies where it is difficult to project their ability to earn future profits. Given the large universe of small-cap companies (>4,000), successful investing in small-caps is determined by an investor's ability to "flip over the rocks" and find new companies. As a result, Chuck relies extensively on Fidelity's dedicated small-cap research outfit and broader group of analysts. He firmly believes that conducting proprietary research with Fidelity's deep resources is the best way to maintain a sustainable competitive advantage over the rest of the investment community.

Chuck implements a "best-ideas" approach to managing money and has a concentrated investment style. This has resulted in a portfolio of 60 - 65 stocks that he believes have the most attractive risk/reward profile. Illustrated below is the investment process Chuck implements to get from the broad universe of small-cap stocks to those in the fund. He initially starts by identifying a focus group or those companies that peak his interest given his general investment philosophy. From there he will meet with the company's management team, conduct original research utilizing a wide-range of resources and ultimately rank order those companies on a risk/reward basis. Those firms with the most compelling overall investment profile make their way into the fund.

Small-cap stocks tend to lead coming out of a recession and employing a value oriented approach in the asset class, over time, has yielded positive results. For investors looking for exposure to both, we believe the Fidelity Small Cap Discovery Fund is certainly worth a look.

For risk, ratings, performance and other data, visit the Fidelity Small Cap Discovery Fund page in the Research > Mutual Funds section.

Meet the Manager

In addition to managing Fidelity Small Cap Discovery, Manager Chuck Myers also helms the Fidelity Small Cap Value Fund which he has managed since March, 2008. Mr. Myers joined Fidelity's small-cap team in 1999 and in 2004 became a portfolio assistant on Fidelity Low Priced Stock Fund alongside Joel Tillinghast, a seasoned small cap investor who was named Marketwatch's Stockpicker of the Decade in 2007. He co-managed Fidelity Small Cap Growth Fund Fund from 2005 until 2006 when he was named portfolio manager of the Fidelity Small Cap Discovery Fund.