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Quality at a Low Cost

This ETF is a bargain for investors who want exposure to profitable companies with durable competitive advantages.

Alex Bryan, 08/19/2016

Good companies don't always make good investments, but they may offer attractive returns relative to the market over the long term when they are trading at reasonable valuations, as they are now. Investors can get low-cost exposure to quality stocks through iShares Edge MSCI USA Quality Factor QUAL (0.15% expense ratio). This exchange-traded fund tracks an index that targets large- and mid-cap U.S. stocks with high returns on equity, low debt/capital ratios, and low variability in earnings growth over the previous five years relative to their sector peers. These characteristics historically have been associated with market-beating performance, particularly in tough market environments. However, they also tend to carry higher valuations, and this fund does not impose a valuation discipline. Consequently, it lands in large-growth territory, though just barely.

The fund's sector-relative approach improves comparability but can also cause it to own some names with lower absolute quality characteristics than it otherwise would. To mitigate unintended sector bets, the fund sets its sector weightings equal to the broad market-cap-weighted MSCI USA Index's when it reconstitutes twice a year. This adjustment can increase turnover and transaction costs, though turnover here has fallen well under the Morningstar Category average. Within each sector, the fund weights its holdings according to both the strength of their quality characteristics and their market capitalization. This skews the portfolio toward stocks with durable competitive advantages, such as Gilead Sciences GILDJohnson & Johnson JNJ, and 3M MMM

The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Their competitive advantages help protect profits and should make them slightly less sensitive to the business cycle than less advantaged firms. For instance, during the bear market from late 2007 to early 2009, the fund's index cumulatively lost 47.0%, while the MSCI USA Index lost 54.7%. However, it will likely underperform during strong market rallies. The fund has not yet distinguished itself from its large-growth category peers during its short record. From its inception in July 2013 through June 2016, it outpaced its parent benchmark by 1.5 percentage points annualized, but it only beat the Russell 1000 Growth Index by 10 basis points.

Fundamental View 
Several research papers have found that stocks with higher profitability and other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts. Cliff Asness and several other principals at AQR published one such paper, "Quality Minus Junk." They found that stocks with high and growing profitability, high payout rates, low market volatility, and low fundamental risk historically outperformed their less-advantaged counterparts.

It is tough to square quality stocks' attractive historical performance with their seemingly attractive characteristics and below-average risk profile. If these firms are so appealing, why would they be priced to offer market-beating returns? One possible explanation is that investors may not have fully appreciated the long-term sustainability of these firms' profits and undervalued them. However, that may not always be the case. Valuations matter, and quality stocks are not necessarily good investments at any price. Not surprisingly, the relationship between profitability and future stock returns is stronger after controlling for differences in valuations. Because this fund does not take valuations into account, it is important to check the valuations of its holdings before buying.

The types of quality stocks that the fund targets are unlikely to offer eye-popping returns, and they could lag the market for extended periods, particularly during strong market rallies. So they are probably not attractive to aggressive investors, which could help cause them to become undervalued. These stocks should reward patient investors with a better risk/reward profile than the broader market over the long term.

As a result of its return-on-equity selection criterion, the fund's holdings look significantly more profitable than the constituents of the broad MSCI USA Index on this metric and return on invested capital. In addition, most of the portfolio is invested in stocks with durable competitive advantages that should allow these attractive profits to persist. In fact, nearly 60% of the portfolio is invested in stocks with wide Morningstar Economic Moat Ratings, our assessment that a firm enjoys a very durable competitive advantage.

The fund's debt/capital selection criterion indirectly skews its portfolio toward profitable companies because more-profitable firms tend to depend less on debt. This metric also penalizes companies that generate high ROEs through debt financing. Targeting stocks with low per-share earnings-growth variability during the past five years tilts the portfolio toward consistent growth companies. It also penalizes stocks that erratically issue new shares to finance their growth.

Alex Bryan is an ETF analyst with Morningstar.

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