Three Reasons Not to Give Up on Quality Stocks

Ryan Leggio Morningstar February 23, 2011

Investing in mega-cap, high-quality companies like Wal-Mart and Johnson & Johnson displayPTip('JNJ', 'JNJ','YTD', '', '', '', '', '', '','msg','P'); 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.

About the Author Ryan Leggio, Esq., is a fund analyst with Morningstar. Contact Author | Meet other investing specialists

The Morningstar Wide Moat Index includes big, financially sound, brand-name companies, such as Coca-Cola displayPTip('KO', 'KO','YTD', '', '', '', '', '', '','msg','P'); and Procter & Gamble displayPTip('PG', 'PG','YTD', '', '', '', '', '', '','msg','P');, 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 displayPTip('KFT', 'KFT','YTD', '', '', '', '', '', '','msg','P'); and Yahoo displayPTip('YHOO', 'YHOO','YTD', '', '', '', '', '', '','msg','P');. The No Moat Index includes companies in cut-throat industries that have trouble earning their cost of capital, such as Ford displayPTip('F', 'F','YTD', '', '', '', '', '', '','msg','P');, Sprint Nextel displayPTip('S', 'S','YTD', '', '', '', '', '', '','msg','P');, and Delta displayPTip('DAL', 'DAL','YTD', '', '', '', '', '', '','msg','P');. 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

Annual Return 2010 (Anlzd) Annual Return 2009 (Anlzd) Morningstar Wide Moat Index TR 8.9 18.3 Morningstar Narrow Moat Index TR 18.7 33.7 Morningstar No Moat Index TR 27.0 47.7 S&P 500 15.1 26.5

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 StyleMorningstar 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

1996 (%) 1997 (%) 1998 (%) 1/1/96-12/31/05 (%) 1/1/97-12/31/06 (%) 1/1/98-12/31/07 (%) S&P 500 (Return) 23.0 33.4 28.6 9.1 8.4 5.9 S&P 500 P/E (TTM) 24.8 28.3 32.9 Russell 2000 (Return) 16.5 22.4 -2.6 9.3 9.4 7.1 Russel 2000 P/E (TTM) 17.7 21.4 27.0 All returns are annualized.

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 displayPTip('VFIAX', 'VFIAX','YTD', '', '', '', '', '', '','msg','P'); 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 VDAIX, 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 displayPTip('BA', 'BA','YTD', '', '', '', '', '', '','msg','P'); and Johnson & Johnson in this Tweedy, Browne letter.)

All Roads Lead to QualityThe 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 displayPTip('FPACX', 'FPACX','YTD', '', '', '', '', '', '','msg','P');, Bill Nygren of Oakmark I displayPTip('OAKMX', 'OAKMX','YTD', '', '', '', '', '', '','msg','P');, Ben Inker of the GMO-run Wells Fargo Advantage Asset Allocation displayPTip('EAAFX', 'EAAFX','YTD', '', '', '', '', '', '','msg','P'); and Don Yacktman of Yacktman Fund displayPTip('YACKX', 'YACKX','YTD', '', '', '', '', '', '','msg','P'); and Yacktman Focus displayPTip('YAFFX', 'YAFFX','YTD', '', '', '', '', '', '','msg','P'); 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

2000 Average Market Cap ($Mil) 2000% Assets Small Caps 2011 Average Market Cap ($Mil) 2011% Assets Small Caps FPA Crescent displayPTip('FPACX', 'FPACX','YTD', '', '', '', '', '', '','msg','P'); 520 88.50 25,400 7.80 Oakmark I displayPTip('OAKMX', 'OAKMX','YTD', '', '', '', '', '', '','msg','P'); 4,600 19.30 38,900 0.00 Wells Fargo Adv Asset Alloc displayPTip('EAAFX', 'EAAFX','YTD', '', '', '', '', '', '','msg','P'); 7,100 17.20 24,000 0.95 Yacktman displayPTip('YACKX', 'YACKX','YTD', '', '', '', '', '', '','msg','P'); 1,700 66.70 51,500 1.30

Stick With ItThere 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 displayPTip('JENSX', 'JENSX','YTD', '', '', '', '', '', '','msg','P');, 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.

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Securities mentioned in this article Ticker Price($) Change(%) Morningstar Rating Morningstar Analyst Report With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds Ryan Leggio has a position in the following securities mentioned above: VIG Find out about Morningstar's editorial policies. Video Reports Rising Commodity Costs Put... More Videos... Most Popular Related News Also in Fund Spy Fund Flows--Mutual Fund Investors Return in Force Sponsored Links Buy a Link Now Sponsor Center Please Wait... MUTUALFUNDS USA_JENSX,USA_OAKMX,USA_FPACX,USA_YACKX,USA_YAFFX,USA_EAAFX,USA_VFIAX,USA_KO,USA_DAL,USA_YHOO,USA_WMT,USA_KFT,USA_S,USA_PG,USA_JNJ,USA_F,USA_BA,USA_VIG,USA_VDAIX FO_USA_JENSX FO_USA_OAKMX FO_USA_FPACX FO_USA_YACKX FO_USA_YAFFX FO_USA_EAAFX FO_USA_VFIAX E0_USA_KO E0_USA_DAL E0_USA_YHOO E0_USA_WMT E0_USA_KFT E0_USA_S E0_USA_PG E0_USA_JNJ E0_USA_F E0_USA_BA FE_USA_VIG FO_USA_VDAIX &primaryKeyword=MUTUALFUNDS 2 {CommentWebService} OAS_AD('Bottom'); Content Partners Site Directory Site Map Our Products Corrections Help Advertising Opportunities Licensing Opportunities Glossary RSS Mobile Portfolio Affiliate Careers Company News International Sites: Australia Canada China France Germany Hong Kong Italy The Netherlands Norway Spain U.K. Stocks by: Title Ticker Popularity Interest Funds by: Title Symbol Popularity Interest Articles by: Title Date Popularity Interest Stock Groups by: Popularity Interest Favorites Title Fund Groups by: Popularity Interest Favorites Title Article Groups by: Popularity Interest Favorites Title Premium Stocks by: Title Ticker Popularity Interest Premium Funds by: Title Symbol Popularity Interest Premium Articles by: Title Date Popularity Interest Independent. Insightful. Trusted. Morningstar provides stock market analysis; equity, mutual fund, and ETF research, ratings, and picks; portfolio tools; and option, hedge fund, IRA, 401k, and 529 plan research. Our reliable data and analysis can help both experienced enthusiasts and newcomers. © Copyright 2010 Morningstar, Inc. All rights reserved. Please read our Terms of Useand Privacy Policy.Dow Jones Industrial Average, S&P 500, Nasdaq, and Morningstar Index (Market Barometer) quotes are real-time. Russell 2000 quote is 10 minutes delayed. var HeaderBox = initBoxQuote("AutoCompleteBox","AutoCompleteDropDown"); HeaderBox.IdleDisplayMsg = ""; HeaderBox.LocalRegion="USA"; HeaderBox.SetPreference('USA','EN',32); var FooterBox = initBoxQuote("AutoCompleteBoxFooter","AutoCompleteDropDownFooter"); FooterBox.IdleDisplayMsg = ""; FooterBox.LocalRegion="USA"; FooterBox.SetPreference('USA','EN',32); //clears all content/image boxes-------------------------------------------------------------------------------------- var imageIDs=new Array('siteDirectoryContent', 'siteMapContent', 'productsContent'); //content boxes .mi_row3{display: none} var _gaq = _gaq || []; _gaq.push(['_setAccount', 'UA-16669347-1']); _gaq.push(['_setDomainName', '.morningstar.com']); _gaq.push(['_trackPageview']); (function() { var ga = document.createElement('script'); ga.type = 'text/javascript'; ga.async = true; ga.src = ('https:' == document.location.protocol ? 'https://ssl' : 'http://www') + '.google-analytics.com/ga.js'; var s = document.getElementsByTagName('script')[0]; s.parentNode.insertBefore(ga, s); })(); var Name = $('meta[name=DC.Creator]').attr("content").split(','); var Title = $('meta[name=DC.Title]').attr("content"); var URL = window.location.href; var Author = Name[1] + " " + Name[0]; var PubDate = $('meta[name=DC.Date]').attr("content"); _gaq.push(['_trackEvent', 'Article Title From Morningstar', Title, URL]); _gaq.push(['_trackEvent', 'Author Name From Morningstar', Author, URL]); _gaq.push(['_trackEvent', 'Article URL From Morningstar', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date From Morningstar', PubDate, URL]); _gaq.push(['_trackEvent', 'Article Title', Title, URL]); _gaq.push(['_trackEvent', 'Author Name', Author, URL]); _gaq.push(['_trackEvent', 'Article URL', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date', PubDate, URL]);

The Morningstar Wide Moat Index includes big, financially sound, brand-name companies, such as Coca-Cola and Procter & Gamble displayPTip('PG', 'PG','YTD', '', '', '', '', '', '','msg','P');, 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 displayPTip('KFT', 'KFT','YTD', '', '', '', '', '', '','msg','P'); and Yahoo displayPTip('YHOO', 'YHOO','YTD', '', '', '', '', '', '','msg','P');. The No Moat Index includes companies in cut-throat industries that have trouble earning their cost of capital, such as Ford displayPTip('F', 'F','YTD', '', '', '', '', '', '','msg','P');, Sprint Nextel displayPTip('S', 'S','YTD', '', '', '', '', '', '','msg','P');, and Delta displayPTip('DAL', 'DAL','YTD', '', '', '', '', '', '','msg','P');. 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

Annual Return 2010 (Anlzd) Annual Return 2009 (Anlzd) Morningstar Wide Moat Index TR 8.9 18.3 Morningstar Narrow Moat Index TR 18.7 33.7 Morningstar No Moat Index TR 27.0 47.7 S&P 500 15.1 26.5

Valuation Is What Matters in the Long Run

Big Is In

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.

Return to Discuss

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

Quality Has Lagged for Two Years in a Row

Valuation Is What Matters in the Long Run

Quality equities offer more for their smaller valuations, too. Vanguard 500's 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 VDAIX, 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 displayPTip('BA', 'BA','YTD', '', '', '', '', '', '','msg','P'); and Johnson & Johnson in this Tweedy, Browne letter.)

Big Is In

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.

Return to Discuss

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

All Roads Lead to QualityThe 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 , Bill Nygren of Oakmark I displayPTip('OAKMX', 'OAKMX','YTD', '', '', '', '', '', '','msg','P');, Ben Inker of the GMO-run Wells Fargo Advantage Asset Allocation displayPTip('EAAFX', 'EAAFX','YTD', '', '', '', '', '', '','msg','P'); and Don Yacktman of Yacktman Fund displayPTip('YACKX', 'YACKX','YTD', '', '', '', '', '', '','msg','P'); and Yacktman Focus displayPTip('YAFFX', 'YAFFX','YTD', '', '', '', '', '', '','msg','P'); 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

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.

Return to Discuss

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

Big Is In

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 , 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.

Return to Discuss

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

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Three Reasons Not to Give Up on Quality Stocks

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