Factor investing, an investment approach that involves targeting specific drivers of return across asset classes, is attracting increasing interest from investors. Factors such as value, size and momentum have a long history in the investment world and have been extensively empirically researched and documented in the academic literature. Although there are different variations for these factors as well, the factor quality is perhaps the most debated, both in academia and in practice.
Quality is such a comprehensive concept that its definition and the way it is measured is mixed, particularly in the investment world. Financial criteria such as profitability ratios (return on equity), profitability (gross profit margin), or balance sheet related indicators such as the debt-to-capital ratio, can provide insight into the quality of a company.
In addition, investors can estimate the quality of a company based on accounting formulas, such as the Altman Z-score (probability of bankruptcy), the Piotroski F-score (financial strength of a company), or the Beneish M-score (manipulation indicator). It does not stop there. Investors can also consider quality characteristics that are less numerical, for example the quality of management, corporate governance and the competitive position of a company.
‘Economic moat’
The latter is also referred to as an “economic moat”. Just as a moat was dug around a castle in the Middle Ages to keep enemies at bay, an economic moat protects a company’s return on invested capital. Or in simpler words: the competitive advantage of a company protects its profitability.
The origin of the economic moat comes from - how could it be otherwise - Warren Buffett. Buffett first wrote about moat in an article in the Fortune business magazine in 1999. This concept of economic moats refers to advantages that protect a company from competitors for a long time.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage,” Buffet wrote. “The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
Competitive advantages
There are various forms of economic moats that can provide firms with a (long-term) competitive advantage. For example, intangible assets (patents, government licences, brand name), switching costs (ease with which a customer can switch to a competitor), network effect (growing customer loyalty), cost advantage (cheaper production) and efficient scale (economies of scale) can lead to a sustainable competitive advantage.
The sustainability of the competitive advantage is more important than the size of the advantage, measured as the return on invested capital minus the weighted average cost of capital. A company must therefore have at least 10 years of expected competitive advantage to qualify for a “narrow moat” rating and at least 20 years for a “wide moat” rating. Companies without a competitive advantage get the qualification “no moat”.
Echiquier World Equity Growth Fund
For this week’s top five, we rank the funds in the Morningstar global large-cap growth equity category on their allocation to stocks with a “Wide moat”. The fund with the largest moat is Echiquier World Equity Growth Fund, whose portfolio consists of a whopping 83.93 percent of companies rated highly competitive by Morningstar equity analysts. The fund, managed by the trio David Ross, Nina Lagron and Louis Bersin, looks for world leaders in their industries that have excellent pricing power. The concentrated portfolio of 25 stocks has nearly 40 percent invested in the technology sector, where Microsoft, Visa and Mastercard are among the top positions. The team reduced the cyclicality of the portfolio in recent months by, among other things, reducing the position in Cummins, a diesel engine manufacturer. To further increase the quality of the portfolio, it was decided to sell the position in Salesforce and to buy Keurig Dr Pepper.
Fundsmith Equity Fund
In third place is Fundsmith Equity Fund, run by Terry Smith. He has an original outlook on investing and dares to go against the grain. Smith is assisted by Julian Robins, a co-founder of the company who has worked with him for more than two decades, and a small team of analysts.
The investment process rests on disciplined and consistent implementation of a well-constructed and structured strategy. The approach is bottom-up, with a combination of quantitative screenings and in-depth fundamental analysis by the team. The manager’s aim is to buy and hold shares in quality companies, if necessary forever. Smith targets companies with a strong competitive advantage (usually based on significant intangible assets) and limited financial leverage. The resulting portfolio of 20-30 stocks is highly concentrated, and includes global players such as LVMH, Philip Morris International and Microsoft.
Top 5 as per Netherlands fund classification:
Top 5 as per Belgian fund classification:
Jeffrey Schumacher is director of research at Morningstar. Morningstar analyses and rates mutual funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners and ranks five investment funds or providers each week.