Buffett's Strategy Lives in These Mutual Funds
ByStan Luxenberg, Special to TheStreet.com
On Wednesday September 30, 2009, 5:00 am EDT


NEW YORK (TheStreet) -- Warren Buffett has long talked about investing in companies with wide "moats." Such businesses dominate their markets for years because of advantages that competitors cannot duplicate.

Longtime Buffett favorites include such powerhouses as Coca-Cola and American Express, companies that can maintain fat profit margins because of their strong brands and unique products.

Recently, Morningstar analysts studied funds that invest in stocks with wide moats. They found that the funds proved relatively resilient during the rough markets of the past year. For many investors, top wide-moat funds could make intriguing holdings that might stabilize portfolios.

The fund study was based on Morningstar's stock-rating system, which evaluates the moats of 2,000 companies. Stocks are rated as having a wide moat, narrow moat or no moat. In order to be ranked in the wide-moat category, a stock must have high returns on capital that can be attributed to factors such as patents or huge economies of scale. Companies with no moats tend to have skimpy profits and tough competition.

For the study, researchers rated funds according to the number of wide-moat stocks they held. Of the 18 funds with the highest concentration of wide-moat stocks, 17 outperformed their categories by wide margins during the downturn of 2008.

One of the top performers in a dismal year was Jensen, which takes stocks that only have long records for delivering high returns on equity. Portfolio holdings include such profit machines as Microsoft and Oracle. During 2008, the fund lost 29% of its value, outdoing the average large-growth fund by 12 percentage points. Other wide-moat funds that outperformed were Dreyfus Core Equity and Haverford Quality Growth.

Betting on wide-moat stocks is hardly a foolproof system. As markets rocketed off the lows in March, many of the leaders were companies with no moats. During the downturn such shaky stocks were clobbered, and now they are roaring back as investors take on more risk.

Still, the wide-moat funds can be sound choices. To follow the Morningstar system, try Elements Morningstar Wide Moat Focus Total Return Index, an exchange traded note. This tracks an index that includes stocks picked by Morningstar. Among the holdings are Harley-Davidson, a company with a long history of retaining loyal customers, and Time Warner Cable, which has the franchise for lucrative New York markets. During the past 12 months, the fund fell 0.8%, exceeding the S&P 500 by 17 percentage points.

For a mutual fund that follows the wide-moat approach, consider Oak Value, which has returned 2% annually during the past decade, outperforming the S&P 500 by 2.9 percentage points. The Oak Value managers seek high-quality companies that sell at discounts of 30% or more to their fair values. Manager Larry Coats says he often follows dominant stocks for years, waiting patiently until the share prices dip into discount territory.

For more than 15 years, he tracked Colgate-Palmolive, the maker of toothpaste and soap. Coats admired the company's rich profit margins, but he never bought because the price was always too high. The manager began acquiring the stock this year as it was pummeled in the market downturn. "This is one of the best businesses in the world, and it finally became undervalued," he says.

Another stock that Coats holds is Automatic Data Processing. The company dominates the market for managing payrolls. With investors worried that layoffs could shrink ADP's revenue, the shares dipped this year. Coats says the company retains a firm grip on its niche and should gain market share during the recession.

To own small- and mid-cap stocks with wide moats, consider FBR Focus, which has returned 12% annually during the past decade. The fund aims to buy growing companies and hold them for years. A favorite holding is American Tower, which operates 23,000 towers used to transmit wireless calls.

In many local markets, the company has a near-monopoly. Some homeowners oppose building towers in their neighborhoods. So once one is built, it can be difficult to construct a second tower nearby, manager David Rainey says. He says American Tower is growing by making acquisitions abroad and finding more cell-phone companies to use existing facilities. "This company can continue achieving above-average growth for the next five or 10 years," he says.

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