Why High Quality Means Lower Risk

The article was published in the February 2016 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

With a market downturn, high quality is again a hot topic. Funds that focus on high-quality stocks have held up wonderfully, just as they did in the 2008–09 bear market. These funds had less impressive performance in the intervening rally because quality is less economically sensitive and because they already have pretty good news priced into the stocks. Of course, quality sounds like a rather fuzzy term, so I thought I’d take some time to explain it and share some of the Morningstar 500 funds that qualify.

Grantham, Mayo, and Van Otterloo & Co. runs a fund dedicated to high quality (unfortunately, GMO Quality IV GQLOX is only available to institutions), and it defines high quality as companies with low leverage, high profitability, and low earnings volatility.

How do you get to be a company like that? You have a brand name that people will pay up for and you have high barriers to competition. The GMO fund’s top names are mostly household brands:

At Morningstar, we call high barriers to competition moats (borrowed from Warren Buffett). Our stock analysts assign a Morningstar Economic Moat Rating to each stock: wide, narrow, or none. We roll those figures up for mutual funds, so one way to screen for high quality is to take the percentage that a fund has in wide-moat stocks and subtract the percentage of no-moat stocks.

Here are the five funds with the highest moat figures:

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Vanguard Dividend Growth

VDIGX has 74% in wide-moat stocks and 2% in no-moat stocks.

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Bridgeway Blue Chip 35 Index

BRLIX has 75% in wide-moat stocks and 3% in no-moat stocks.

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Jensen Quality Growth

JENSX has 68% in wide-moat stocks and nothing in no-moat stocks.

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Dreyfus Appreciation

DGAGX has 67% in wide-moat stocks and 3% in no-moat stocks.

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Columbia Dividend Income

GSFTX has 62% in wide-moat stocks and 2% in no-moat stocks.

That’s a pretty good list of high-quality funds that you can expect to hold up well in a downturn. In fact, two months into 2016, all five had top-quintile performance, led by Jensen Quality Growth, which was in the top 1%.

Screening for low leverage using funds’ debt/capital ratios yields a less satisfying list. This is a trait shared by many faster-growing companies, some of which are vulnerable to a sell-off. For example,

So, how can one use high-quality funds like those listed above? A couple of ways come to mind. You can use them to tone down risk in your equity portfolio. If you have a number of higher-risk funds or stocks, these are names that come through in the clutch most of the time. (Don’t look for guarantees here, just probabilities.) Both deep-value and fast-growth funds go through extreme bouts of high returns and severe losses. So, a high-quality fund can smooth some of that out. But you have to understand going in that these funds will lag when your other funds are racing--and be willing to hold on then, or you’ll miss the good part in a downturn.

A second way to use them is to buy them during a bear market, rather than sitting on the sidelines. They are less risky than the market as a whole, so you can sleep at night knowing that the Johnson & Johnsons of the world will do just fine. True, you won’t make as much money if you timed the market bottom correctly with a deep-value or high-growth fund, but it’s better than not putting your money to work in a bear market or selling into a bear market. I bought Jensen Quality Growth in early 2009 in this way.

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