The Risk of 'Quality'

Last month, we took a look at "invisible" risk factors and concluded that many investors likely have exposures they're not aware of. Nearly 50% of the S&P 500's underlying revenue comes from abroad, for example, and many of us probably have little insight into how much "moat" risk we run.

The moat risk factor, however, runs both ways. Stocking a portfolio with companies that sport competitive advantages, or a moat--one of the key attributes that generally constitutes investment "quality"--sounds like a permanently perfect strategy. In reality, it's a perfectly temporal one--a recipe for success in some market environments, not so much in others.

Sinking in Moats: A Tale of Two Funds
Morningstar's equity analysts assign moat ratings to 2,000 stocks. Mapping those ratings to the universe of mutual funds, our research finds that--true to its name-- GMO Quality III  (GQETX) resides among the "moatiest" of large-cap funds. Interestingly, so does Vice (VICEX), an overpriced offering with a unique marketing angle: It invests in so-called sin stocks.

Gimmicky? Well, yes. But Vice's impressive moat rating is no fluke:  Philip Morris (PM),  Altria (MO), and  Diageo (DEO)--wide-moat companies all--are among its top holdings. The GMO fund's top positions include  Oracle (ORCL),  Microsoft (MSFT), and  Johnson & Johnson (JNJ), but it owns shares of Philip Morris, too.

All told, of the portfolio holdings our equity analysts have rated, each fund has more than 90% of assets invested in firms with moats. Both are well invested in companies that earn high marks in our financial-health category, too--another quality indicator.

Here is another thing these funds have in common: In 2009, each landed in the large-blend category's bottom decile.

Other Signs of Quality
To be sure, these data points--moat and financial health--constitute powerful portfolio-construction and risk-management tools, particularly when used in tandem with other Morningstar metrics. The Wide-Moat/Grade-A Profit screen that I ran for last month's column, for example, produced a model portfolio whose historical total returns shellacked the broader market.

Yet that impressive profile notwithstanding, the past isn't prologue. And while back-testing can be instructive, its real-world limits are clear: Wide-moat stocks don't always lead the market. Moreover, many companies now seen as undoubtedly high quality, with great financials and a moat--no-brainers, basically--looked quite a bit different back when brains were required to see their potential.

What attributes, for example, would we have needed to screen for to identify pre-iPhone  Apple (AAPL) as among the market's most promising prospects, a company destined to ramp up revenue and free cash flow dramatically over the course of the past decade? Would it have qualified as a high-quality company then? Maybe, but maybe not--Apple began the decade with two consecutive years of negative free cash flow before righting itself in 2003.

What, in other words, did it take to spot Apple's potential after the Newton and before the iPhone?

Before Quality Shows
Maybe we should ask  Fidelity Contrafund (FCNTX) manager Will Danoff.

A review of a decade's worth of his fund's annual reports finds Apple making its debut in 2004, with a position size of roughly 1.3 million shares. By 2005, Danoff owned more than 11.5 million shares of the company, and the figure has grown larger since then. Indeed, as of Sept. 30, 2010, Contrafund was Apple's top fund shareholder, with 16.4 million shares accounting for 6.9% of Contrafund's assets.

We don't know Danoff's precise cost basis in the position. We do know that around the time of Contrafund's 2004 annual report, Apple traded in the high $40s--well above our equity analysts' then-current fair value estimate of $26. It finished that fiscal year with some $8.3 billion in revenue.

Not too shabby, of course--except by comparison. Today, shares of Apple trade around $316. And thanks in large part to the iPhone--just a twinkle in Steve Jobs' eye back in 2004--Apple reported revenue of roughly $65.3 billion for fiscal 2010, nearly 8 times its 2004 figure. Free cash flow over the period grew by more than 20 times.

Strike the Right Quality Balance
As that example helps to illustrate, erring too hard on the side of quality may mean missing out on the kind of explosive returns Apple has delivered--and that Contrafund shareholders have enjoyed.

The so-called junk rally of 2009--a year paced by the market's most speculative stocks--provides another example of what might be called "quality risk"--that is, the risk of mistaking the set of financial attributes that analysts refer to as "quality" for the sense of that word that conveys a more or less permanently true value judgment.

The truth, of course, is that sometimes the market bids up "quality" attributes and--as happened during 2009's flight to risk--sometimes it marks them down relative to "junk" whose upside potential seems greater.

A Place for Junk
How much of an investor's portfolio should be allocated to racier equities--either directly or through mutual funds--is of course in the eye of the shareholder. And clearly, in terms of the risk of permanent capital loss, moat-free firms whose fortunes are tethered to nondiversified revenue streams (or to easily replicated products) are more dangerous to own than wide-moat industry dominators.

Still, in the same way that stuffing money under a mattress isn't a risk-free endeavor (boulder-sized dust bunnies and spending-power erosion await), failing to consider promising up-and-comers for at least a portion of your portfolio can be risky business, too.

In an upcoming column, I'll highlight ways to use Morningstar tools and data to uncover such companies and the topnotch funds that specialize in them. (If you'd like to get a head start, click here for a free two-week Morningstar.com Premium Membership.) In the realm of investing, after all, "quality" can sometimes be a vice, and "junk" isn't always a dirty word.