61 / 708
10
With a market downturn, talk of high quality has re-
turned as funds that focus on high-quality stocks
have held up wonderfully, just as they did in the
2008
–
09
bear market. These funds had less impressive
performance in the intervening rally because quality is
less economically sensitive and because they
already have pretty good news priced into the stocks.
Of course, quality sounds like a rather fuzzy term,
so I thought I’d take some time to explain it and share
some of the Morningstar
500
funds that qualify.
Grantham, Mayo, and Van Otterloo runs a fund
dedicated to high quality (unfortunately it’s only avail-
able to institutions), and it defines high quality as
companies with low leverage, high profitability, and
low earnings volatility.
How do you get to be a company like that? You have a
brand name that people will pay up for and you
have high barriers to competition. The
GMO
fund’s top
names are mostly household brands:
Johnson &
Johnson
JNJ
,
Microsoft
MSFT
,
Procter & Gamble
PG
,
Oracle
ORCL
, and
Alphabet
GOOG
.
I mentioned high barriers to competition, and at Morn-
ingstar we call those moats (borrowed from Warren
Buffett). Our stock analysts assign a Morningstar Eco-
nomic Moat Rating to each stock: wide, narrow, or
none. We roll those figures up for mutual funds, so one
way to screen for high quality is to take the percent-
age a fund has in wide-moat stocks and subtract the
percentage of no-moat stocks. Here are the five funds
with the highest moat figures:
•
Vanguard Dividend Growth
VDIGX
has
74%
in wide-
moat stocks and just
2%
in no-moat stocks.
•
Bridgeway Blue Chip 35 Index
BRLIX
has
75%
in
wide-moat stocks and
3%
in no-moat stocks.
•
Jensen Quality Growth
JENSX
has
68%
in wide-moat
stocks and nothing in no-moat stocks.
•
Dreyfus Appreciation
DGAGX
has
67%
in wide-moat
stocks and
3%
in no-moat stocks.
•
Columbia Dividend Income
GSFTX
has
62%
in wide-
moat stocks and
2%
in no-moat stocks.
That’s a pretty good list of high-quality funds that you
can expect to hold up well in a downturn. In January
2016
, all five had top-quintile performance, led
by Jensen Quality Growth, which was in the top
1%
.
Just using debt/capital yields a less satisfying list, as
this is a trait shared by many faster-growing com-
panies, some of which are vulnerable to a sell-off. For
example,
Touchstone Sands Capital Select
Growth
PTSGX
has a debt/capital ratio of
25%
, tops
in the M
500
, but its January
2016
losses were in the
bottom
3%
of the large-growth Morningstar Category.
So, how can one use high-quality funds like those
listed above? A couple of ways come to mind. You can
use them to tone down risk in your equity portfolio.
If you have a number of higher-risk funds or stocks,
these are names that come through in the clutch
most of the time. (Don’t look for guarantees here, just
probabilities.) Both deep-value and fast-growth
funds go through extreme bouts of high returns and
severe losses. So, a high-quality fund can smooth
some of that out. But you have to understand going in
that these funds will lag when your other funds are
racing, or you’ll miss the good part.
A second way to use them is to buy them during a bear
market. They are less risky than the market as a
whole, so you can sleep at night knowing that the John-
son
&
Johnsons of the world will do just fine
come hell or high water. True, you won’t make as much
money if you timed the market bottom correctly with
a deep-value or high-growth fund, but it’s better than
not putting your money to work in a bear market
or selling into a bear market. I bought Jensen Quality
Growth in early
2009
in this way.
K
Why High Quality Means Lower Risk
The Contrarian
|
Russel Kinnel
Our Contrarian Approach
I go against the grain to
find overlooked funds that may
be ready to rally.