Small- and Mid-Cap Funds With Moats in the Making

In a recent Fund Spy article, Ryan Leggio discussed some compelling reasons why investors should not turn their backs on funds with a large share of their assets in wide-moat stocks. We've also written about the value of owning wide-moat stocks in a portfolio and how to screen for moat-heavy mutual funds using our  Premium Fund Screener.

In the realm of small- and mid-cap funds, however, it can be difficult to turn up offerings with a large share of their assets in wide-moat stocks. The reasons are twofold. First, a stock must be under analyst coverage to earn any moat assignment at all, and the universe of companies that have Morningstar analyst coverage skews toward large-cap names. Even more important, wide-moat companies are frequently large firms, simply because these firms' sustainable competitive advantages have given them the ability to grow to a broad size.

But some investors ask if there are small- and mid-cap funds with "emerging moat" names--companies that are on their way to building sustainable competitive edges versus their peers.

To find out, we turned to the Premium Fund Screener to ferret out topnotch small- and mid-cap domestic stock funds that had earned average moat ratings of narrow or higher. On the fees front, we layered on screens for no-load funds with expenses below the category average, and we also required that managers have helmed the fund for at least a decade. Finally, to ensure that the screener would yield purely small- and mid-cap funds, we eliminated any sector funds that made it through our filters.

The screener yielded 11 results--all of which happened to be narrow-moat funds. You can  click here to replicate this screen. Here are three of the highlights.

 Ariel (ARGFX)
Managers John Rogers and John Miller keep this mid-blend fund lean with fewer than 40 companies--firms that may be under the radar but that the managers believe have long-term value. The managers seek smaller-cap stocks that are selling at a discount of 40% to their estimates of fair value, but they avoid value traps by focusing on companies that generate plenty of free cash flow and have sound balance sheets. Investors may find the fund's middling performance for the past five years a stumbling block, but while Rogers and Miller are decidedly contrarian in their stock picks, sticking to their guns has translated into long-term success for the fund.

 FAM Value (FAMVX)
Like the managers of the aforementioned offering, FAM Value managers Thomas Putnam and John Fox seek undervalued firms that are leaders within their industries. While sector concentrations are common for this fund, management keeps a lid on risk by insisting on clean balance sheets (hence the fund's below-average debt/capital ratio) and strong returns on capital. For exposure to the mid-cap market without a lot of volatility, this fund merits investor consideration.

 Meridian Growth (MERDX)
There's a lot to like about this mid-cap growth fund. Longtime manager Rick Aster has proved his stripes as a talented stock-picker, snatching up high-quality, but previously expensive, firms when they've fallen to attractive prices. Although the fund lands in the often-volatile mid-growth category, investors need not fear a bumpy ride with this fund. Aster uses a disciplined strategy that focuses on companies with superior profitability and minimal debt, and he then holds them for the long term. This fund presents a compelling choice as a core holding for moderately conservative investors, but Morningstar analyst Michael Breen notes that the fund's tax efficiency has been less impressive and recommends that investors hold it in a tax-advantaged account.