Fund Moat and Uncertainty Ratings Revisited

The past six months have been a wild time for investors. Back on March 9, 2009, the S&P 500 hit a 12-year low, and investors' confidence was shot. Since then, the S&P 500 has gained nearly 50%, and most other stock market indexes are up comparable amounts. As is the case in many rallies that follow deep bear markets, the stocks that got hit the hardest in the market collapse, including financials, commodities, and highly leveraged companies in 2008, have bounced back the strongest. This year's rally has been driven by risky, low-quality investments, while stable, high-quality fare has been left behind.

It's possible to quantify the scale of this pro-risk, anti-quality market using two ratings that Morningstar equity analysts assign to each stock they cover. Economic moat measures the strength of a company's competitive advantages, while fair-value uncertainty estimates the stability and predictability of its future cash flows. As Morningstar.com markets editor Jeremy Glaser recently pointed out, moats have been inversely correlated with fund performance lately. Between the market bottom and July 31, the average wide-moat stock gained 4.81%, the average narrow-moat stock gained 16.6%, and the average no-moat stock gained 26.1%. That's the reverse of what happened in 2008, when wide-moat stocks were the best performers.

As my colleague Sonya Morris has noted, this tendency extends to mutual funds. Many funds that favor wide-moat stocks, such as  Jensen (JENSX), have trailed their category peers since March, while many with a high percentage of no-moat stocks, such as  Schneider Value , have outperformed. We decided to measure this tendency systematically by looking at two numbers that we first introduced in December 2008: weighted-average moat and fair-value uncertainty ratings for funds.

How We Did It
We used the same methodology as in our original study from late 2008. First, we assigned numerical values to the moat and fair-value uncertainty ratings. Wide-moat stocks such as  Coca-Cola (KO) and  Wal-Mart (WMT), which have strong competitive advantages, scored a 3; narrow-moat stocks, with less-compelling advantages, got a 2; and no-moat stocks, which lack such advantages, tallied a 1. Stocks with low fair-value uncertainty, which tend to have stable businesses and predictable cash flows, got a 1; those with uncertainty scores of medium, high, very high, or extreme received values of 2, 3, 4, and 5, respectively. Note: With moat scores, higher is better, but with fair-value uncertainty scores, lower is better.

We restricted the study to funds in our large-value, large-blend, and large-growth Morningstar categories, because big domestic stocks are more likely to have moat and uncertainty ratings than mid-cap, small-cap, or foreign stocks. For each fund within that group, we looked at its most recent portfolio as of Feb. 28, 2009, a few days before the market bottom. We figured the asset-weighted average of all the moat and fair-value uncertainty ratings in each portfolio, then we ranked all the funds from highest to lowest in each of the two criteria. To measure performance during the market rally, we took each fund's percentile ranking within its category for the six months from Feb. 28 through Aug. 31, 2009, ranging from 1 (best) to 100 (worst).

What We Found
The results are essentially the inverse of what we found in December 2008. Back then, investors were flocking to safety and stability, and funds with the highest average moat ratings and lowest average fair-value uncertainty ratings were among their categories' best performers over the previous year. Now, though, many of the funds with the highest average moat ratings have been among the worst performers over the past six months, while those with the lowest average moat ratings have done extremely well. We've summarized the key results in four tables in this PDF document.

Table 1 shows the 20 funds in our group that had the highest average moat rating as of Feb. 28, including each fund's percentile ranking over the six months through Aug. 31. As a group, they've done poorly; 14 of the 20 have trailed their category, and seven of them rank in the bottom decile. Not surprisingly, several of these were also among the highest-moat funds in our earlier study, and they did extremely well in 2008. For example, Destination Select Equity , AMF Large Cap Equity (IICAX), and Jensen were all top performers in 2008. A few outliers have managed to do well during the recent rally despite their wide-moat bias, but usually because of some distinct characteristic. Rydex Dow 2x Strategy (RYCYX), for example, uses leverage to amplify its returns, which also amplified its losses in 2008.

Table 2 shows the 20 funds with the lowest average moat rating as of Feb. 28, and here it is a different story. Of these funds, 16 beat their category over the six-month period, and 12 ranked in the top decile. These include the above-mentioned Schneider Value, which has been helped by big weightings in commodity and financial stocks. Other funds have also benefited from big stakes in similarly risky stocks that tend to have no moat or a narrow moat. These are disproportionately large-value funds (12 out of 20), which is not surprising given that value funds tend to hold a lot of financials. Few financials now have wide moats, and the sector has been the second-best performer so far in 2009.

Table 3 shows the funds with the lowest average fair-value uncertainty rating as of Feb. 28. The pattern here is similar to what we saw with the high-moat funds in Table 1. Of the funds with the lowest average fair-value uncertainty, 16 of 20 trailed their category over our six-month period; seven were in the bottom decile, and Rydex Dow 2x Strategy was again an outlier. Seven of these funds were also in Table 1, but 13 of them were not, so the similarity in return patterns is striking.

Finally, Table 4 shows the funds with the highest average fair-value uncertainty as of Feb. 28. These funds, like those in Table 2, have mostly done well; 17 of 20 beat their categories, with 14 ranking in the top decile. Yet here, too, they're mostly different funds; the top seven funds are also among the low-moat funds of Table 2, but none of the others are. Most of these newcomers are large-growth funds, and some of them have average moat ratings well above 2.0, indicating that they hold quite a few wide-moat stocks but also some riskier fare that has helped recently.  Morgan Stanley Capital Opportunities  is a good example. Lead manager Dennis Lynch specifically looks for wide-moat stocks but also holds aggressive stocks with plenty of uncertainty, such as Chinese Internet stocks Tencent Holdings and  Baidu (BIDU).

What It Means
It's clear that average moat and fair-value uncertainty ratings have once again been good at explaining fund performance over the past six months. However, this has been an unusual market in many ways, just as 2008 was unusual in the opposite direction, so it's not a good idea to extrapolate too much from these specific numbers. There are good funds of all types; two of the wide-moat, low-uncertainty funds in Tables 1 and 3 are Morningstar Analyst Picks (Jensen and  Sequoia (SEQUX)), as are two of the low-moat, high-uncertainty funds in Tables 2 and 4 (Schneider Value and  Columbia Value & Restructuring ).

Average moat and fair-value uncertainty ratings don't fully explain the quality of a fund's holdings, but they do say a lot about how a fund is likely to behave in different market conditions. A high-moat, low-uncertainty fund is likely to hold up relatively well in bear markets, so it might be a good option for investors who put a priority on avoiding downside risk. A low-moat, high-uncertainty fund is likely to be significantly more volatile, capable of doing well in aggressive markets but getting crushed when things go south. There can be exceptions, but these results show that both measures are valuable tools for explaining fund performance and that they can be useful in selecting candidates for hedging and diversification purposes.