Beware of cyclical valuations

Why the run-up for cyclical stocks may not continue at the torrid pace set early in 2021.

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The global economy seems to be on the cusp of a broad recovery at roughly midyear, although there’s reason to think a healthy part of the future performance of cyclical stocks may already be priced into the market, says Fidelity’s Vince Montemaggiore.

“Rather than paying too much for popular recovery plays, I’ve focused on high-quality companies I think have been left behind in the recent rotation into value,” says Montemaggiore, portfolio manager of Fidelity® Overseas Fund (FOSFX).

Montemaggiore sees plenty of evidence that the recent run-up for cyclical stocks may not continue at the torrid pace set in late 2020 and early 2021. To illustrate, from April 2020 through February 2021, cyclicals within the fund’s benchmark, the MSCI EAFE Index, outperformed defensive stocks by a wider margin than in any other similar time frame going back roughly 20 years.

Another gauge is looking at six-month rolling returns for shares of BNP Paribas (BNPQF), a highly cyclical stock, versus Nestlé (NSRGF), a highly defensive stock. As of the end of May, BNP topped Nestlé to the same degree only twice since the early 1990s, Montemaggiore says.

Rather than chasing cyclical stocks with momentum, Montemaggiore is finding better value in good quality businesses that may be less economically sensitive in the near term but that have favorable medium-term prospects to grow earnings.

One such company held in the fund as of May 31, he says, was China-based NetEase (NETTF). Montemaggiore adds that about three-quarters of this company’s business is online games, which has been growing at a mid-teens cumulative growth rate, driven by a broad portfolio of legacy titles and a strong pipeline of new games. In addition, there remains a significant opportunity to expand its product offering into the U.S. and Japan. He also sees value in this founder-led company’s online education and music streaming businesses, the latter of which he thinks could be IPO’d to fully recognize its value.

Similarly, the fund owned Germany-based Merck KGaA (MKKGY) (not to be confused with the U.S. drugmaker), which sells the “picks and shovels” to support the significant capacity expansion occurring within biopharma manufacturing. Montemaggiore says Merck KGaA is a complex conglomerate that has struggled to grow earnings since 2016, largely driven by one division that is now negligible in the mix. What’s left is a collection of high-quality businesses tied to strong secular trends in life sciences and semiconductor manufacturing, and a pharma business with a strong pipeline. Global peers trade at significantly higher valuation multiples than Merck KGaA, he says.

“These are examples of stories I think can perform well over a multiyear timeframe, given their combination of valuation, quality, and growth in free cash flow per share,” Montemaggiore says.

Fidelity® Overseas Fund held securities mentioned in this article as of its most recent holdings disclosure. For specific fund information, including holdings, please click on the fund trading symbol above.

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