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Quality Quicksand

Are the market's financially healthy laggards finally poised to lead?

In the upcoming issue of Morningstar FundInvestor, I take a look at the risk of quality at a pair of funds that, despite portfolios stuffed with financially healthy overachievers, have languished in recent years, at least in relative terms. Amid a rally paced by more-speculative fare, that's not much of a surprise. Indeed, that in a nutshell is the risk of quality: the likelihood of underperformance when the fear/greed pendulum swings toward greed.

In conducting research for the article, I used Morningstar.com's Premium Stock Screener to zero in on those areas of the Morningstar Style Box that are currently loaded with quality and those that are relatively bereft of it. Once the results were in, I gave Morningstar's director of fund research, Russ Kinnel, a single-question pop quiz: Which areas of the style box did he think were the least and most quality-centric?

Kinnel's response and the full results appear below. But try to resist scrolling down without first jotting down your response to that same question.

Pop Quiz
One fair response to the question, of course, is: What do you mean by "quality"?

In talking recently with the team at Rainier Investment Management about their  JHancock3 Rainier Growth (RGROX) and  Rainier Large Cap Equity (RIMEX) charges, the definition of "quality" quickly became a hot topic when I asked about the apparent quality bias of those funds' lineups. The term can be useful, we agreed, to the extent that it refers to a firm's financial health, particularly its balance-sheet strength as gauged by (among other metrics) the company's debt/equity ratio.

I'd add a qualitative factor--economic moat--to the mix, as well. To the extent that a company has sustainable competitive advantages that can keep competitors at bay, that's another indication of quality.

High Quality, Low Rewards
Yet, as we've seen during the past two-plus years, such positive financial-health attributes can, in some environments, detract from the performance of funds whose managers favor them. To paraphrase Ben Graham, the market may be a voting machine in the short term and a weighing machine over time, but quality (as defined by financial-health stats) can underperform for lengthy stretches. During the trailing 10 years through May 27, 2011, for example, the blue-chip-rich Dow Jones Industrial Average has badly lagged the far-lower-quality Russell 2000 Value Index, trailing that bogy by roughly 4.2% annualized in the period.

If Graham is correct, then, it's worth asking what exactly the market is weighing. In answering that question, it's also worth remembering that Graham is a value-investing luminary, one who was more willing than Warren Buffett (his one-time student) to snap up shares of subpar companies when the fundamental spadework he conducted uncovered large gaps between the stock prices and intrinsic values of unproven or even impaired businesses.

Risk, Meet Reward
Is all this just another way of saying that more risk typically generates greater rewards?

Not exactly. Contemporary keepers of Graham's value faith, such as Charlie Dreifus of  Royce Special Equity (RYSEX) and Don Yacktman of  Yacktman (YACKX) and  Yacktman Focused (YAFFX), hardly go out of their way to find untested firms or companies that are in decline or that may never take flight. Instead, they seem to grasp that there's a mixed (or at least an imprecise) metaphor at the heart of Graham's maxim: What's being "weighed" in his assessment is really a measurement of distance or volume: the gap between share price and business value.

In some market environments, there's plenty of value to be found among financially distressed or more-speculative names. During other periods, the reverse is true. In those times, investors whose portfolios tilt toward funds focused on high-quality companies are poised to win the relative-returns race.

In light of the market's lengthy, low-quality bender, the current environment may offer an opportunity to tilt toward quality on the cheap, too, at least in terms of relative valuations.  JHancock US Global Leaders Growth (USGLX) looks interesting in that light. It targets an area of the market currently rich with quality--large-cap growth--and the fund's concentrated portfolio of just 30 names boasts robust financial health. According to Morningstar Equity Research, all but three of its holdings have an economic moat, too.

Parnassus (PARNX)--the flagship fund of its namesake shop--strikes a similarly high-quality profile. Performance at this socially screened large-growth vehicle has been middling in the year to date--and even worse during the last 12 months--but the fund's long-haul track record remains strong. It's been managed since its 1984 inception by firm founder Jerome Dodson, who eats plenty of his own cooking: He has more than $1 million dollars invested here.

Mapping Quality
For those looking for quality in other areas of the market, here are the full results of the screens I ran to find the highest- and lowest-quality style box squares. Results are sorted based on the second column's values, which reflect the percentage of companies within a style box square that sport a Morningstar Financial Health grade of at least B.

Results in the third column reflect not only the financial-health requirement of B or better, but also the percentage of companies that Morningstar Equity Research believes have an economic moat. That whittles down the universe to just the approximately 1,700 firms Morningstar covers; I've bolded the highest and lowest figures in that column so you can see the results based on the more stringent criteria.

Happy navigating!

Style% B or Better
Financial Health
% B or Better
+ Economic Moat
Mid Growth61.322.9Mid Blend44.520.7Large Growth44.535.8Small Growth40.32.7Large Blend34.326.9Mid Value31.815.9Large Value20.717.6Small Blend20.21.5Small Value9.20.6

 

Kinnel, incidentally, was 50/50, nailing small-value as the lowest-quality area of the market, but gauging large-blend as the Style Box's highest-quality spot. How'd you do? Let us know in the comments area.

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