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Funds That Go Moatless

Price discipline can offset some of the risks of investing in no-moat firms.

Andrew Daniels, CFA, CMA, 07/24/2017

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, cost advantage, high switching costs, and efficient scale. Firms that do not receive a narrow or wide moat rating do not possess durable competitive advantages, in the view of Morningstar analysts, and hence they may not earn above-average returns over the long term.

While investing in no-moat companies brings risks, price discipline can offset them. Listed below are three value-oriented funds that invest heavily in no-moat companies: All but one have Morningstar Medalist ratings.

Artisan Value ARTLX had 35% of its assets in firms rated by Morningstar analysts and with no economic moat as of March 2017. The fund’s veteran managers some­times 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 2017, 30% 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. That bet on energy and basic materials was the main source of outperformance during a stellar showing in 2016 as commodity prices rebounded, but it has been the main drag on performance for the year to date.

Silver-rated Invesco Comstock ACSTX had 29% of its assets in firms with economic moat ratings of none as of March 2017. Lead manager Kevin Holt and team look for firms that look cheap on a variety of valuation metrics and generally won’t pay up for higher-quality firms.

Oftentimes, this deep-value approach leads the team to bet on companies and/or sectors that have fallen out of favor. The team increased exposure to energy stocks such as Devon Energy DVNHess HES, and Suncor Energy SU--all of which are no-moat stocks--as oil prices plum­meted in late 2014 and throughout 2015. That energy overweighting dragged on results in 2014 and 2015 but was the top contributor to performance in 2016 as oil prices rebounded.

More recently, the fund added no-moat KeyCorp KEY in late 2016, believing it was trading at attractive valuation despite investor concerns about its First Niagara acquisition. The fund also picked up generic drug manufacturer Mylan MYL in early 2017, believing that concerns over its EpiPen specialty drug were overblown.

Andrew Daniels, CFA, CMA, is an analyst covering equity strategies on Morningstar’s manager research team.

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