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Fund Spy

Funds That Go Moatless

Price discipline can offset some of the risks of investing in no-moat firms.

In a free-market economy, capital seeks the areas of highest return, and whenever a firm develops a profitable product or service, competitive forces are fast to drive down economic profits. Only firms with economic moats--a structural competitive advantage that allows firms to earn long-term above-average returns on capital--are able to fend off competition, the theory goes.

To help investors identify firms with moats, our equity analysts assign one of three Morningstar Economic Moat Ratings: none, narrow, or wide. Some attributes that drive economic moats include network effects, intangible assets, cost advantage, high switching costs, and efficient scale. Firms that do not receive a narrow or wide moat rating do not possess durable competitive advantages, in the view of Morningstar analysts, and hence they may not earn above-average returns over the long term.

While investing in no-moat companies brings risks, price discipline can offset them. Listed below are three value-oriented funds that invest heavily in no-moat companies: All but one have Morningstar Medalist ratings.

 Artisan Value (ARTLX) had 35% of its assets in firms rated by Morningstar analysts and with no economic moat as of March 2017. The fund’s veteran managers some­times lean toward more-cyclical firms when they deem valuations to be compelling. That’s been the case in recent years: The fund, which has a Morningstar Analyst Rating of Bronze, increased its exposure to economically sensitive fare--which tends to lack economic moats--and has bigger stakes in energy and basic materials.

As of June 2017, 30% of the fund’s assets were in energy and basic-materials stocks, and all but two of those 10 holdings had economic moat ratings of none. That bet on energy and basic materials was the main source of outperformance during a stellar showing in 2016 as commodity prices rebounded, but it has been the main drag on performance for the year to date.

Silver-rated  Invesco Comstock (ACSTX) had 29% of its assets in firms with economic moat ratings of none as of March 2017. Lead manager Kevin Holt and team look for firms that look cheap on a variety of valuation metrics and generally won’t pay up for higher-quality firms.

Oftentimes, this deep-value approach leads the team to bet on companies and/or sectors that have fallen out of favor. The team increased exposure to energy stocks such as Devon Energy (DVN),  Hess (HES), and  Suncor Energy (SU)--all of which are no-moat stocks--as oil prices plum­meted in late 2014 and throughout 2015. That energy overweighting dragged on results in 2014 and 2015 but was the top contributor to performance in 2016 as oil prices rebounded.

More recently, the fund added no-moat  KeyCorp (KEY) in late 2016, believing it was trading at attractive valuation despite investor concerns about its First Niagara acquisition. The fund also picked up generic drug manufacturer  Mylan (MYL) in early 2017, believing that concerns over its EpiPen specialty drug were overblown.

Despite lackluster performance over short periods, Holt’s record speaks for itself: Since he joined the fund in August 1999, the fund’s 7.3% annualized gain through June 2017 outpaced the Russell 1000 Value Index’s 6.4% return and the typical large-value peer’s 5.4% return.

Neutral-rated  Miller Opportunity (LMOPX) had 32% of its assets in firms with economic moats of none as of March 2017. Lead manager Bill Miller and a small supporting team follow a contrarian, valuation-driven strategy, seeking stocks that they believe have solid, long-term fundamental outlooks but are facing temporary headwinds.

Recently, that approach has led them to healthcare-oriented names such as drugmaker  Endo International (ENDP) and IT service provider  athenahealth . Miller also owns no-moat homebuilders  Lennar (LEN) and  PulteGroup (PHM), believing both are trading at compelling valuations with the potential to deliver double-digit earnings growth in upcoming years.

He also favors domestic airlines, as industry consolidation and lower oil prices have improved operating metrics; no-moat  Delta Air Lines (DAL), American Airlines Group (AAL), and  United Continental (UAL) accounted for more than 12% of assets as of June 2017.

The fund has been a top performer in the bull market that’s reigned for most of the trailing five years through June 2017, outperforming the Russell Midcap Index by an annualized 582 basis points and 98% of its mid-blend peers. But the fund’s elevated risk profile still leaves it prone to substantial declines during market downturns.

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