A Tale of Two Markets

But unlike last year, when high-quality stocks were a place of refuge, investors have shown an appetite for lower-quality fare in 2009. It's not unusual to see more-speculative stocks lead the way early in a market recovery, and this year has been no exception.

Morningstar's moat ratings provide a window onto this trend. Morningstar equity analysts assign moat ratings to all 2,000 stocks they cover. A wide-moat business possesses some competitive advantage that will allow it to keep its competitors at bay for an extended period of time, in the analysts' view. In contrast, no-moat firms generally operate in extremely competitive industries where it's difficult to gain an edge over rivals.

Viewing 2008 and 2009 through the prism of our moat ratings displays a tale of two markets. In 2008, as the moat barometer at right reveals, wide-moat stocks held up much better than no-moat stocks. But that trend has reversed in 2009. No-moat stocks have significantly outperformed those stocks with economic moats.

Late last year, my colleague David Kathman examined how this phenomenon affected fund performance. He found that funds that favored wide-moat stocks held up better than the competition in 2008.

Not surprisingly, we're seeing a reversal of that trend in 2009. Funds loaded with wide-moat stocks are struggling on a relative basis so far this year.

 Jensen provides a case in point. This large-growth fund, unlike many racier competitors, invests almost exclusively in high-quality stocks. Indeed, at present, all of the stocks in the portfolio possess an economic moat, and given its extremely low turnover rate, it sported a very similar profile throughout 2008. Not surprisingly, Jensen held up much better than the competition last year, but it's bringing up the rear in 2009.

Meanwhile, funds with smaller allocations to wide-moat stocks have soared in 2009. Consider  Schneider Value , one of the worst performers in the large-value category in 2008. This fund looks for deep values, including companies in distressed situations; therefore, it ends up with only a minority of assets in stocks with established moats, which tend not to find themselves in deep-value territory. That composition took a toll on Schneider Value's performance last year. But it's experienced an abrupt reversal of fortune in 2009.

That's not to say that one fund's approach is better than the other's. In fact, both Jensen and Schneider Value are Fund Analyst Picks. However, to use a fund well, it's important to understand how it's likely to behave in different market conditions, and lately, Morningstar moat ratings have been a good way to put fund performance in the appropriate context.

Over the past two years, funds with different moat characteristics have behaved quite differently. This lack of correlation suggests that the Morningstar moat rating can be another way of looking at diversification. The best portfolios are those that combine uncorrelated investments, so that when one fund is struggling, it's likely that another might be thriving. Granted, diversification didn't work all that well last year as almost every asset class, aside from Treasury bonds, lost considerable ground. Still, a portfolio would have benefited from some exposure to wide-moat stocks in 2008. And over the long term, we believe the principles of diversification will prove sound. Just as mixing funds with different styles, market caps, and regional characteristics can add diversification to a portfolio, combining funds with different moat characteristics can also help smooth a portfolio's overall returns.

Note: A correction was made to this article since original publication. Please click here for details.