Five Great Funds That Own Wide-Moat Stocks

The stock market has been on quite a ride since March of this year. Major indexes are up more than 50% from their lows, driven by huge gains from the same type of risky investments that got pummeled in 2008's meltdown. While things might look much better for investors than they did a year ago, there are still plenty of reasons to be nervous. Most observers expect a slow and muted economic recovery over the next year, and many also think that the market is pricing in a stronger recovery than is likely to occur.

Mutual fund investors who want to exercise caution have options. One of the simplest is to buy stock funds that focus on relatively safe, stable firms with strong competitive advantages that allow them to get through tough economic times without too much damage. Even if we don't have a full-blown market correction any time soon, such quality stocks are likely to perform better than the risky stuff over time.

One way to identify high-quality mutual funds is through the economic moat ratings that Morningstar's stock analysts assign to each stock they cover. The ratings measure the strength of a company's competitive advantage, if any. Wide-moat stocks such as  Coca-Cola (KO) have significant competitive advantages over their peers, while narrow-moat stocks have lesser competitive advantages, and no-moat stocks lack such advantages. Calculating the weighted-average moat rating for a mutual fund portfolio gives a measure of how moat-heavy that fund is.

We first calculated these mutual fund moat ratings in December 2008 for all the domestic large-cap funds in our database. We found that funds with the highest average moat ratings tended to be among their categories' best performers in 2008, when investors fled to safety and anything risky got hammered, while funds with the lowest average moat ratings tended to be among the worst performers in 2008. A few months ago, we revisited the question, and found that from March 1 to Sept. 1, 2009 (roughly the first six months of the rally), the reverse was true: The widest-moat funds were among the worst performers, and the lowest-moat funds were among the best.

We decided to look at fund moat ratings once again in order to find good funds that are particularly heavy in wide-moat stocks. The following five funds are all Analyst Picks within their categories, and they have average moat ratings in the top 10% of all large-cap funds. They all sport excellent long-term records and tend to hold up better than most in downdrafts; conversely, they tend to lag racier rivals in speculative bull markets, despite posting solid absolute returns. All five had top-decile returns in 2008, but four of them are trailing their categories in 2009.

 Aston/Montag & Caldwell Growth  (MCGFX)
This fund focuses on quality growth stocks, but with a valuation discipline that sets it apart. Manager Ron Canakaris and his team look for firms that can grow their earnings at least 10% annually. They buy only stocks that are trading at least 10% below their estimated present value, and sell those that get more than 20% above that value. As of October 31, nine of the top 12 holdings were wide-moat stocks, including such household names as  Google (GOOG), Coca-Cola, and  Visa (V).

 Jensen (JENSX)
Jensen is another large-growth fund with exacting standards. The managers consider only companies that have achieved returns on equity of at least 15% each year for the past decade, and they buy only those trading at a substantial discount to their intrinsic value. Almost by definition, a stock must have an economic moat to achieve that kind of long-term profitability, and indeed this fund has one of the highest average moat ratings in our database. As of September 30, all 30 stocks in the portfolio had at least a narrow moat, and the top six were all wide-moat stocks, led by top holdings  3M (MMM),  Microsoft (MSFT), and  Johnson & Johnson (JNJ).

 Sequoia (SEQUX)
The concept of an "economic moat" has been popularized by investing legend Warren Buffett, so it's no surprise that Sequoia shows up on this list. It was managed for many years by Buffett protege Bill Ruane, who died in 2005. Bob Goldfarb has been with the fund for 35 years and became manager more than a decade ago. He and David Poppe comanage the fund in a very Buffettesque manner. More than 20% of the fund's assets are in  Berkshire Hathaway (BRK.B), Buffett's investment vehicle, and the other holdings include many other wide-moat stocks. These include some household names, such as  Wal-Mart (WMT), as well as lesser-known stocks such as  Fastenal (FAST).

 Vanguard Dividend Growth  (VDIGX)
As its name implies, this fund focuses on dividend-paying stocks with long records of increasing their payouts. Such companies must feature steady and strong free cash flows over time, and economic moats are a key ingredient in that recipe. Of the fund's top 16 holdings (as of September 30), 11 have wide moats by Morningstar's reckoning, including top holdings  Automatic Data Processing (ADP) and  United Parcel Service (UPS).

 Vanguard Primecap  (VPMCX)
The management team at Vanguard Primecap uses a stock-picking strategy that's somewhat more flexible than many of those described above, but no less successful. That strategy can best be described as "contrarian growth," and it results in a portfolio of very high-quality stocks with lots of growth potential but temporarily depressed valuations. Of the top 20 holdings as of September 30, an amazing 16 had wide moats, including many health-care stocks ( Amgen (AMGN),  Novartis (NVS),  Eli Lilly (LLY)) and technology stocks ( Adobe (ADBE),  Oracle (ORCL)).

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