Large and mega-cap stocks: Look for opportunities in financials and energy

Large and mega-cap stocks produced strong returns through mid-December of 2014 and portfolio manager Matt Fruhan expects the biggest stocks to continue posting solid returns in 2015, based on a foundation of healthy balance sheets, profits, cash flow and revenue diversification, as well as attractive yields.

While large stocks lead other parts of the market in 2014, Fruhan says they are still relatively cheap compared with other parts of the market. “The S&P; 100 is trading at about 15 times earnings, which is by no means expensive historically,” he says.

According to Fruhan, the major risk heading into 2015, is Federal Reserve policy. He expects the Fed to move short-term rates higher if employment continues to strengthen. “The question is, what happens to P/E ratios in a rising-rate environment?” he explains. “If global bond investors see relative value in U.S. bonds, this demand could continue to hold yields down at the long end of the curve. But everybody should be aware of the potential for the Federal Reserve to raise short-term interest rates and the pressures that will put on stock valuations.”

As a result, Fruhan expects an uptick in volatility and is being cautious about companies trading at premium valuations that have been propelled by short-term earnings growth. Instead, he is focusing on more reasonably valued companies with long-term earnings growth upside and exposure to the recovering economy.

What kinds of companies might win in an environment of rising rates and an expanding economy? Fruhan points to financials companies. Rising rates, he argues, would likely increase financials’ earning power by increasing their net interest income and net interest margins.

He is also watching energy stocks, searching for opportunities that may appear as other investors flee the sector. Oil prices declined sharply in the second half of the year due to both oversupply and declining global demand. “When there’s a supply/demand adjustment, there’s usually a shakeout, and that creates pretty good buying opportunities,” he notes.

Fruhan is taking a cautious approach to health care and utilities in light of his expectations for higher interest rates, especially following the sectors’ strong performance in 2014. “If we do get into a rising rate environment, I think the most fixed income–like pieces of the equity market—REITs, utilities, and some pieces of the health care sector, like pharmaceuticals—might see some valuation pressure,” he says.

Learn more

• Matt Fruhan manages Fidelity^® Large Cap Stock Fund (FLCSX) and Fidelity^® Mega Cap Stock Fund (FGRTX).
• John Roth manages Fidelity^® New Millennium Fund (FMILX) and Fidelity^® Mid-Cap Stock Fund (FMCSX).
• Joel Tillinghast manages Fidelity^® Low-Priced Stock Fund (FLPSX).

Mid-cap stocks: Think about consumer plays, banks, and shale companies

The relatively benign U.S. macroeconomic environment for much of 2014 helped mid-cap stocks produce modest year-to-date gains as of December 15. Against this backdrop, portfolio manager John Roth is cautiously optimistic about the asset class’s prospects for 2015.

“As I look at the mid-cap landscape, I would say that valuations are a little bit above average, and expectations are fairly high for some parts of the market,” he says. “The more growth-oriented the stock, the higher the expectations that investors have priced in. There are opportunities, but you have to be a little more cautious at this point in the cycle.”

Roth says that mid-cap equities have the potential to post moderate positive performance thanks to the improved economy, as housing has inched higher, the job situation has improved, and commercial credit has picked up.

Consumer-related mid-caps could be attractive, says Roth, as falling commodity prices might leave more money in consumers’ pockets for luxury goods and durables, products that are made to last for an extended period of time. He’s also interested in health care services companies, which he thinks offers significant upside potential.

Like Fruhan, Roth is cautious on REITs and utilities, but finds financials and energy appealing. Mid-cap banks are one of the few parts of the market that offer both improving fundamentals and attractive valuations, he says. Within energy, Roth is focusing on U.S.-based shale exploration and production companies, looking for opportunities to benefit from disruption in the sector.

At the same time, he notes that volatility increased in the fourth quarter of 2014 and is likely to continue. “Volatility is incredibly difficult to predict, because it’s really a function of U.S. macroeconomic issues, global issues and political events around the world,” he explains. “In general, though, volatility creates opportunities for active managers. And my assumption is that volatility is probably here to stay for a while.”

Learn more

• Matt Fruhan manages Fidelity^® Large Cap Stock Fund (FLCSX) and Fidelity^® Mega Cap Stock Fund (FGRTX).
• John Roth manages Fidelity^® New Millennium Fund (FMILX) and Fidelity^® Mid-Cap Stock Fund (FMCSX).
• Joel Tillinghast manages Fidelity^® Low-Priced Stock Fund (FLPSX).

Small-cap stocks: Focus on stocks with higher yields and growth potential

Small-cap stocks struggled for much of 2014, with year-to-date performance essentially flat as of mid-December, peppered with dips of as much as 7% during the year. This is in sharp contrast to 2013, when the asset class gained 37%. Looking ahead to 2015, Fidelity portfolio manager Joel Tillinghast believes small caps are poised to deliver moderate performance based on solid growth in profits.

Tillinghast notes that small caps, particularly, may benefit from the strengthening U.S. economy. “The economy of the United States is one of the strongest in the world, and the U.S. stock market has outperformed most stock markets, especially in U.S. dollar terms, since the dollar has been on a tear,” he says. “If the U.S. stays the place to be, I think that small caps being more U.S.-centric will make for a better 2015.”

Most small-cap banks and insurance companies are rather simple and boring—in a good way. They sell at reasonable valuations, and Tillinghast thinks they can do somewhat better than the small-cap market overall. Retail and consumer stocks that are not heavily exposed to energy-producing regions also look good to him.

In this environment, Tillinghast favors stocks that offer higher yields, but still have some growth potential. That means he’s avoiding utilities, master limited partnerships (MLPs), and some REITs: Though these sectors offer high yields, they tend not to have the growth prospects he seeks—and he says many are overvalued as well.

Like his colleagues, Tillinghast is keeping a close eye on energy and energy service shares, looking for opportunities to acquire stocks of energy companies that are trading at a discount to his estimates of their fair market value.

Learn more

• Matt Fruhan manages Fidelity^® Large Cap Stock Fund (FLCSX) and Fidelity^® Mega Cap Stock Fund (FGRTX).
• John Roth manages Fidelity^® New Millennium Fund (FMILX) and Fidelity^® Mid-Cap Stock Fund (FMCSX).
• Joel Tillinghast manages Fidelity^® Low-Priced Stock Fund (FLPSX).