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Will These Moat-Heavy Funds Bounce Back in 2011?

Quality large-cap funds have lagged lately but could be poised for a rebound.

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Large-cap stock funds didn't get much love from investors in 2010. While the average fund in the three domestic large-cap categories posted double-digit gains for the year, these funds saw big outflows as investors continued a trend that began in 2009, pulling money out of domestic stock funds and putting it into hot areas like emerging markets and commodities. The large-growth category had $45 billion in outflows in 2010, by far the most of any Morningstar category, and large-blend and large-value were next with $17 billion and $4.5 billion, respectively, in outflows.

Yet there's reason to think that those who stuck with domestic large-cap funds will be rewarded. As Russel Kinnel recently noted in his annual "Buy the Unloved" study, the fund categories that get the most outflows in any given year tend to outperform the categories with the biggest inflows over the next several years. This is essentially a contrarian strategy, avoiding what's hot and going where others are stampeding for the exits. Domestic-stock funds are relatively unpopular now due to a general perception that most economic growth in the coming years will come from overseas, especially emerging markets such as China and India.

To be even more contrarian, we can look at large-cap funds that focus on "high-quality" stocks, meaning those that are stable and profitable with strong competitive advantages. Such stocks had a hard time keeping up in the rally of the past two years, which was largely driven by risky assets. A good proxy for quality, in this sense, is the economic moat ratings that Morningstar stock analysts assign to all the stocks they cover. A wide-moat stock has strong competitive advantages; a narrow moat means weaker competitive advantages; and stocks with no moat lack such advantages. Calculating the asset-weighted average moat rating for all the stocks in a fund's portfolio gives a good idea of the quality and stability of that portfolio.

We've studied these fund moat ratings a few times over the past two years--for example, here, here, and here--and found that funds with high average moat scores tend to hold up well in down markets but lag in speculative bull markets. These figures are the basis for the "Average Moat Rating" datapoint, now available in the  Premium Fund Screener on Morningstar.com, which classifies each stock fund into one of five groups, ranging from "Wide" down to "No Moat."

The following table shows the largest funds in the three large-cap domestic-stock categories (large value, large blend, large growth) that have an Average Moat Rating of "Wide," meaning that they're especially heavy in wide-moat stocks. We show each fund's size, its Morningstar rating, and its percentile ranking in its category in 2010 and over the trailing three years as of Jan. 27.

Large-Cap Funds With Wide Average Moat Rating

 CategorySize ($Mil)Mstar Rating% Rank Cat 2010% Rank Cat 3 YrsGMO Quality III (GQETX)Large Blend15,829 9931Fidelity Series 100 (FOHIX)Large Blend6,258.2 7266Vanguard Div Gr (VDIGX)Large Blend4,675 818Jensen (JENSX)Large Growth3,475.9 8119Yacktman (YACKX)Large Value3,402.7 611Dreyfus Appreciation (DGAGX)Large Blend3,248.4 2734MFS Mass Inv Gr Stk (MIGFX)Large Growth3,133.2 5918Yacktman Focused (YAFFX)Large Value1,984.3 731Eaton Vance Tax-Mgd (ETTGX)Large Blend1,309.2 7238JHFunds2 US MultiSec (JHUMX)Large Blend1,052.7 9528

 

As a group, these funds did not do very well in 2010: Nine of the 10 trailed their categories. That's not too surprising, given that the stock market's biggest gains last year came from relatively risky fare. On the other hand, most of these funds have beaten their peers over the past three years, mainly because they held up so well in 2008, and several of them are among our favorites, with excellent long-term records.

The largest fund on the list in terms of assets,  GMO Quality III (GQETX), typically lands at or near the top on the list of funds with the highest average moat scores. It's an institutional fund run by a team at Grantham, Mayo, Van Otterloo & Co., whose founder is veteran value investor (and frequent market pessimist) Jeremy Grantham. This fund's top 10 holdings consist entirely of wide-moat stocks, but several of those, notably  Microsoft (MSFT),  Johnson & Johnson (JNJ), and  Pfizer (PFE), have been flat over the past year, and other holdings have posted losses. As a result, it was one of the worst-performing large-blend funds in 2010, but its long-term record remains solid.

A similar fund aimed at retail investors is  Jensen (JENSX), which my colleague Bridget Hughes recently wrote about. It's a concentrated fund consisting entirely of companies that have earned a return on equity of at least 15% for 10 straight years, a feat that basically requires a moat, usually a wide moat. This fund also had a tough year in 2010, relatively speaking, but has posted excellent long-term returns with very low volatility.

The third-biggest fund on the list,  Vanguard Dividend Growth (VDIGX), has followed a similar pattern. Here the focus is on dividend-paying stocks, which tend to be stable cash cows in any case, and manager Don Kilbride especially likes those that look cheap and are capable of sustainable dividend growth for many years. As of Sept. 30, 2010, all but one of the portfolio's 46 stocks had either a wide or narrow moat. Like the other funds mentioned above, this fund lagged its peers in 2010, in part thanks to disappointing returns by such top holdings as Johnson & Johnson and  Medtronic (MDT), but it has some of the best three- and five-year returns in the large-blend category.

Finally, there's  Yacktman (YACKX) and Yacktman Focused (YAFFX), both managed by former Morningstar Fund Manager of the Year Don Yacktman and his son Stephen. They're more willing to hold cash than the other funds here and are more focused on valuation. The stocks they own nearly all have moats, with wide-moat giants such as  Coca-Cola (KO),  Procter & Gamble (PG), and Microsoft among the top holdings. It's no coincidence that Coke and P&G are both among the big holdings of Warren Buffett's  Berkshire Hathaway (BRK.B), as the very concept of an "economic moat" was popularized by Buffett. Back in March 2010, when we looked at which funds had the most overlap with Berkshire's top stock holdings, Yacktman and Yacktman Focused were numbers one and three on the list, with GMO Quality III right behind and  Dreyfus Appreciation (DGAGX) also in the top 10.

We've long been Buffett fans at Morningstar, and these funds are good examples of how a Buffett-style approach can lead to good long-term results--even if it lags in certain environments, as it did in 2010.

 

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.