Three Reasons Not to Give Up On Quality Stocks, Funds

Investing in mega-cap, high-quality companies like  Wal-Mart (WMT) and  Johnson & Johnson (JNJ) hasn't been the best investment strategy the past two years. While these stocks have appreciated, they've underperformed the S&P 500 Index by a wide margin, as shown in the table below that compares the returns of Morningstar's Wide, Narrow, and No Moat indexes with those of the S&P 500.

The Morningstar Wide Moat Index includes big, financially sound, brand-name companies, such as  Coca-Cola (KO) and  Procter & Gamble (PG), that Morningstar's equity analysts believe can earn returns above their cost of capital for years to come. In other words, these are high-quality stocks. The Narrow Moat Index is composed of companies with less-durable competitive advantages, including  Kraft (KFT) and  Yahoo . The No Moat Index includes companies in cut-throat industries that have trouble earning their cost of capital, such as  Ford (F),  Sprint Nextel , and  Delta (DAL). The S&P 500 Index meanwhile is a mix of all three moats--41% wide, 46% in narrow, and 13% none.

Quality Has Lagged for Two Years in a Row

Given the results of the four benchmarks over the past couple of years, it might be tempting to write off the high-quality bucket and funds that focus on it. Investors, however, should resist that temptation for a few reasons: reversion to the mean, attractive valuations, and good examples.

In and Out of Style
Morningstar data show that it is not only possible for viable investment strategies and styles to underperform for three or more years, but also that it happens frequently. In all Morningstar equity categories, a large percentage of top-performing managers over the past 10 years have underperformed for at least a three-year stretch.

Investment styles go out of favor periodically, too. Undervalued companies often lag over the short term on their way to long-term outperformance. In the late 1990s, for example, overvalued, big technology, media, and telecommunication companies beat undervalued small caps for several years in a row before the market corrected.

Valuation Is What Matters in the Long Run

More specifically, small caps lagged large caps in 1996, 1997, and 1998, but if you had bought small caps on Jan. 1 of each of those years and held them for the subsequent 10 years, you would have done better than if you had chosen large caps.

Valuation Matters
Not much in the equity market looks as attractive as it did two years ago--the S&P hit its most recent low in March 2009--when stocks of all stripes looked cheap. But after two years of broad market gains, the shares of quality companies are arguably still undervalued from a bottom-up perspective. Morningstar equity analysts currently think wide-moat companies are, on average, 2% undervalued while firms with no competitive advantage are about 10% overvalued.

Quality equities offer more for their smaller valuations, too.  Vanguard 500's (VFIAX) portfolio, which mimics the S&P 500 Index, has an average P/E of 17.1 and an average return on equity of 20.2%. Meanwhile,  Vanguard Dividend Appreciation V , which has more money in wide-moat stocks than other Vanguard stock funds because it tracks an index of companies with long records of dividend increases, has a P/E of 16.1 but an average return on equity of 25.4%. Vanguard 500's and Vanguard Dividend Appreciation's average earnings growth rates are about the same: 6.3% and 6.5%, respectively. So, for a slightly lower valuation than the S&P 500, Dividend Appreciation offers exposure to more-profitable companies, growing earnings at a similar rate. (For a good explanation on the relationship between price/earnings ratios and returns on equity, see the discussion of  Boeing (BA) and Johnson & Johnson in this Tweedy, Browne letter.)

All Roads Lead to Quality
The valuations of wide-moat stocks aren't lost on some of the mutual fund industry's best go-anywhere managers. Steven Romick of  FPA Crescent (FPACX), Bill Nygren of  Oakmark I (OAKMX), Ben Inker of the GMO-run  Wells Fargo Advantage Asset Allocation  (EAAFX) and Don Yacktman of  Yacktman Fund (YACKX) and Yacktman Focus (YAFFX) all think these companies still look reasonably valued on an absolute basis. They also think they look more attractive relative to the broad market, lower-quality fare, and small-cap stocks. These managers don't have anything against smaller or more cyclical companies as a rule. In fact, they all emphasized small-cap stocks a decade ago because that's where they were finding values. They aren't finding many bargains there anymore.

Big Is In

Stick With It
There are powerful reasons to invest in high-quality stocks and funds that own them: They won't stay out of favor forever, their valuations are still attractive, and some very savvy, successful, long-term investors favor them.

Don't settle for just any fund that focuses on high-quality stocks, though. To ensure you capture as much of wide-moat stocks' potential returns as possible, stick with low-cost funds run by experienced managers who have a long history of successfully executing their strategies, like  Jensen  (JENSX), a Morningstar Fund Analyst Pick in the large-growth category. For passive investors, Vanguard Dividend Appreciation's holdings have one of the highest average moat ratings among large-cap funds, and the fund has one of the lowest expense ratios among wide-moat domestic-equity funds. (Morningstar.com Premium Members can use the Average Moat Rating data point in the  Premium Fund Screener to find other wide-moat funds.)

The more venturesome might consider a wide-ranging fund, such as Yacktman, that currently favors high-quality stocks. Just recognize that a fund like that might not own high-quality stocks forever.

A stake in wide-moat stocks requires patience and reasonable expectations. High-quality stocks could lag the market for a while longer, but in the long run they should pay off. They still belong in your portfolio.