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Quality Quicksand

Are the market's financially healthy laggards finally poised to lead?

Shannon Zimmerman, Fund Analyst, 06/02/2011

In the upcoming issue of Morningstar FundInvestor, I take a look at the risk of quality at a pair of funds that, despite portfolios stuffed with financially healthy overachievers, have languished in recent years, at least in relative terms. Amid a rally paced by more-speculative fare, that's not much of a surprise. Indeed, that in a nutshell is the risk of quality: the likelihood of underperformance when the fear/greed pendulum swings toward greed.

In conducting research for the article, I used Morningstar.com's Premium Stock Screener to zero in on those areas of the Morningstar Style Box that are currently loaded with quality and those that are relatively bereft of it. Once the results were in, I gave Morningstar's director of fund research, Russ Kinnel, a single-question pop quiz: Which areas of the style box did he think were the least and most quality-centric?

Kinnel's response and the full results appear below. But try to resist scrolling down without first jotting down your response to that same question.

Pop Quiz
One fair response to the question, of course, is: What do you mean by "quality"?

In talking recently with the team at Rainier Investment Management about their JHancock3 Rainier Growth RGROX and Rainier Large Cap Equity RIMEX charges, the definition of "quality" quickly became a hot topic when I asked about the apparent quality bias of those funds' lineups. The term can be useful, we agreed, to the extent that it refers to a firm's financial health, particularly its balance-sheet strength as gauged by (among other metrics) the company's debt/equity ratio.

I'd add a qualitative factor--economic moat--to the mix, as well. To the extent that a company has sustainable competitive advantages that can keep competitors at bay, that's another indication of quality.

High Quality, Low Rewards
Yet, as we've seen during the past two-plus years, such positive financial-health attributes can, in some environments, detract from the performance of funds whose managers favor them. To paraphrase Ben Graham, the market may be a voting machine in the short term and a weighing machine over time, but quality (as defined by financial-health stats) can underperform for lengthy stretches. During the trailing 10 years through May 27, 2011, for example, the blue-chip-rich Dow Jones Industrial Average has badly lagged the far-lower-quality Russell 2000 Value Index, trailing that bogy by roughly 4.2% annualized in the period.

If Graham is correct, then, it's worth asking what exactly the market is weighing. In answering that question, it's also worth remembering that Graham is a value-investing luminary, one who was more willing than Warren Buffett (his one-time student) to snap up shares of subpar companies when the fundamental spadework he conducted uncovered large gaps between the stock prices and intrinsic values of unproven or even impaired businesses.PAGEBREAK

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