(PUB) Investing 2016

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11 Morningstar FundInvestor August 2016
In a free-market economy, capital seeks the areas of
highest return, and whenever a firm develops a
profitable product or service, competitive forces are
fast to drive down economic profits. Only firms
with economic moats—a structural competitive
advantage that allows firms to earn long-term
above-average returns on capital—are able to fend
off competition, the theory goes.
To help investors identify firms with moats, our equity
analysts assign one of three Morningstar Economic
Moat Ratings: none, narrow, or wide. Some attributes
that drive economic moats include network effects,
intangible assets, a cost advantage, high switching
costs, and efficient scale. Firms with a moat rating
of none do not possess durable competitive advantages,
and hence they may not earn above-average returns
over the long term. Firms with no moats can be vulner-
able to recessions and competition alike.
We found three funds that heavily invest in no-
moat companies. While doing so has risks, price disci-
pline can overcome some of the problems of having
no moat. We consider this a risk but wouldn’t suggest
that these funds have strategies that are broken.
In fact, all three have Morningstar Medalist ratings.
Artisan Value ARTLX has 42% of its assets in firms
with economic moat ratings of none, up from 29%
12 months ago. The fund’s veteran managers some-
times lean toward more-cyclical firms when they
deem valuations to be compelling. That’s been the
case in recent years: The fund, which has a
Morningstar Analyst Rating of Bronze, increased its
exposure to economically sensitive fare—which
tends to lack economic moats—and has bigger stakes
in energy and basic materials. As of June 2016,
32% of the fund’s assets were in energy and basic-
materials stocks, and all but two of those 10
holdings had economic moat ratings of none. Though
that bet on energy and basic materials dragged on
results in recent years as commodity prices fell, it’s
been the main source of outperformance this year as
commodity prices have rebounded.
Bronze-rated T. Rowe Price Value TRVLX has 22% of its
assets in firms with economic moat ratings of none,
up from 15% 12 months ago. Lead manager Mark Finn
looks for stocks that appear cheap relative to historical
standards, the broad market, or their sum-of-the-parts
value because of a temporary headwind. The fund has
picked up several no-moat stocks during the past year,
including energy firms Royal Dutch Shell RDS.A and
Total TOT. To be fair, Finn has had an underweighting
in energy since oil prices began falling in 2014 and
only recently began increasing exposure there. Finn also
purchased no-moat Tyson Foods TSN, believing that
it would become more brand-focused following its acqui-
sition of Hillshire Farms, and it’s now a top holding in
the portfolio. Finn’s record speaks for itself: Since taking
over the fund in December 2009 through June 2016,
its annualized gain of 12.3% beats 87% of its large-
value peers.
Silver-rated Invesco Comstock ACSTX has 20% of
its assets in firms with economic moat ratings of none,
up from 16% 12 months ago. The managers look for
firms that look cheap on a variety of valuation metrics
and generally won’t pay up for higher-quality firms.
This deep-value approach occasionally leads it to buy
companies vulnerable to a downturn. The team
increased exposure to energy stocks such as Devon
Energy DVN, Hess HES, and Suncor Energy SU—
all of which are no-moat stocks—as oil prices plum-
meted in late 2014 and throughout 2015. That
energy overweighting dragged on results in 2014 and
2015 but has helped performance thus far in 2016
as oil prices have rebounded. Still, the fund has under-
performed nearly 85% of its large-value peers in
2016 through June because of its overweighting to
poor-performing financials—specifically banks. K
Contact Andrew Daniels at
Funds That Go Moatless
Red Flags | Andrew Daniels
What is Red Flags?
Red Flags is designed to alert
you to funds’ hidden risks. Such
risks can take many forms,
including asset bloat, the
departure of a solid manager, or
a focus on an overhyped asset
class. Not every fund featured
in Red Flags is a sell, and in fact,
some are good long-term
holdings. But investors should
be prepared for a potentially
bumpier ride in the near future.