(PUB) Investing 2016

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Why High Quality Means Lower Risk The Contrarian | Russel Kinnel

• 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.

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:

Our Contrarian Approach I go against the grain to find overlooked funds that may be ready to rally.

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

• 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.