(PUB) Investing 2016

11

August 2016

Morningstar FundInvestor

Funds That Go Moatless Red Flags | Andrew Daniels

that bet on energy and basic materials dragged on results in recent years as commodity prices fell, it’s been the main source of outperformance this year as commodity prices have rebounded. Bronze-rated T. Rowe Price Value TRVLX has 22% of its assets in firms with economic moat ratings of none, up from 15% 12 months ago. Lead manager Mark Finn looks for stocks that appear cheap relative to historical standards, the broad market, or their sum-of-the-parts value because of a temporary headwind. The fund has picked up several no-moat stocks during the past year, including energy firms Royal Dutch Shell RDS .A and Total TOT . To be fair, Finn has had an underweighting in energy since oil prices began falling in 2014 and only recently began increasing exposure there. Finn also purchased no-moat Tyson Foods TSN , believing that it would become more brand-focused following its acqui- sition of Hillshire Farms , and it’s now a top holding in the portfolio. Finn’s record speaks for itself: Since taking over the fund in December 2009 through June 2016 , its annualized gain of 12 . 3% beats 87% of its large- value peers. Silver-rated Invesco Comstock ACSTX has 20% of its assets in firms with economic moat ratings of none, up from 16% 12 months ago. The managers look for firms that look cheap on a variety of valuation metrics and generally won’t pay up for higher-quality firms. This deep-value approach occasionally leads it to buy companies vulnerable to a downturn. 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 plum- meted in late 2014 and throughout 2015 . That energy overweighting dragged on results in 2014 and 2015 but has helped performance thus far in 2016 as oil prices have rebounded. Still, the fund has under- performed nearly 85% of its large-value peers in 2016 through June because of its overweighting to poor-performing financials—specifically banks. K Contact Andrew Daniels at andrew.daniels@morningstar.com

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, a cost advantage, high switching costs, and efficient scale. Firms with a moat rating of none do not possess durable competitive advantages, and hence they may not earn above-average returns over the long term. Firms with no moats can be vulner- able to recessions and competition alike. We found three funds that heavily invest in no- moat companies. While doing so has risks, price disci- pline can overcome some of the problems of having no moat. We consider this a risk but wouldn’t suggest that these funds have strategies that are broken. In fact, all three have Morningstar Medalist ratings. Artisan Value ARTLX has 42% of its assets in firms with economic moat ratings of none, up from 29% 12 months ago. The fund’s veteran managers some- times 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 2016 , 32% 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. Though

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.