It doesn't take a Ph.D. in finance to figure out what the investing game plan is for GMO Quality IV Fund (GQEFX), a best mutual fund. In a nutshell? Buy quality stocks.
When administering the quality test, Tom Hancock, 60, portfolio manager of GMO Quality, looks for companies that can pretty much survive anything.
"They're robust, resilient companies," Hancock said.
Best Mutual Fund Focuses On Quality
The companies that GMO Quality owns are established, mature and proven winners. Kind of like the hockey player who scores 40-plus goals every season, rather than the talented prospect who has yet to prove he can put up big numbers in the pros.
"We're not investing in science projects and new, unproven ideas," Hancock said.
Hancock covets stocks that can reinvest capital at a high rate of return and earn more money on those investments. Just as compounding can help you build wealth in your 401(k), owning shares of a company that compounds money internally can make you big money, too.
GMO Quality, a 2023 IBD Best Mutual Funds winner, focuses on companies that can churn out double-digit returns without the benefit of price-to-earnings multiples expanding. Think strong balance sheets and moats protecting the business. Strong long-term trends and long growth tailwinds also benefit these companies.
"Quality companies have opportunities other companies don't have," Hancock said.
Quality Pays Off For Best Mutual Fund
The focus on quality has paid off for investors. GMO Quality's performance has topped the returns of the S&P 500 in the past one-, three, five- and 10-year periods (through Aug. 11, 2022), according to fund-tracker Morningstar. The top-performing fund's annualized total return of 13.5% over the past 10 years has beaten 99% of its peers.
So far this year, GMO Quality's 22.4% return is more than 4 percentage points better than the broad market's 17.5% advance. Another plus: This top-performing mutual fund provides downside protection when the market stumbles. Last year, for example, GMO Quality declined 15.2%, a smaller loss than the S&P 500's 18.2% drop.
Smoothing Out Rough Markets
Indeed, owning quality companies allows GMO Quality to withstand market storms. And come out on the other side in a good position to thrive anew.
"We don't want to be blitzkrieged by fundamental events like Covid-19," Hancock said. Even if the companies in the GMO Quality portfolio stop earning money for a couple of quarters, "they're not going out of business, and that's an important thing," Hancock added. "If a company can't handle adversity, they're probably not a high-quality company."
Risks Facing Best Mutual Fund
The two biggest risks facing the nascent bull market now is the threat of de-globalization as well as the fact that much of the hype surrounding AI is already priced into the market, Hancock says.
A focus on quality and a small research and analytical team also lends itself to a smaller portfolio. At the end of the second quarter, GMO Quality held 42 stocks. And the top-performing fund's biggest sector weightings were in technology (35.7% of fund assets) and health care (24.3%).
From a diversification standpoint, Hancock doesn't see a material advantage of holding more names. There's a downside to a bigger portfolio. "Not only would we be getting lower-quality businesses, we'd also be getting lower-quality investment analysis."
Top Bets For Best Mutual Fund
The top-performing fund's top holdings include names like Microsoft, UnitedHealth Group, Amazon.com, Apple, Facebook parent Meta Platforms, Eli Lilly and IT consulting firm Accenture.
GMO Quality's current overweight of tech and health care stocks plays into Hancock's definition of quality.
Tech, Hancock says, is a big beneficiary of secular growth themes. Software and semiconductor stocks are fund favorites. And health care is benefiting from both product innovation and favorable demographics amid the graying of America. Medical equipment makers and drugmakers are high on Hancock's list of favorite stocks to own.
"(Both sectors) have a long growth tailwind," Hancock said.
Betting Big On Tech
Big weightings in tech and health care give the portfolio a barbell-type risk profile. Tech, of course, is the more aggressive part of the portfolio. While health care provides defensive ballast. "We do want that balance between quality growth and defensive value quality," Hancock said.
Identifying companies that are well-positioned to benefit from long-term trends, such as the electrification of transportation, artificial intelligence (AI), pharmaceuticals and the Internet of Things, is key to generating returns.
"The advantage of owning these companies is they're just more durable," Hancock said. "Any of these drivers have long legs. And that is the trick of it."
Going With Leaders As A Best Mutual Fund
GMO Quality fund holdings have the advantage of incumbency, which makes it harder for new upstarts to dislodge them from their leadership positions, says Hancock.
Despite a sizable 67% run-up for Amazon this year, Hancock still sees opportunity in the stock. Amazon generates the bulk of its revenue from online sales and its cloud-computing business, Amazon Web Services. GMO Quality, which has a value tilt, started a position in Amazon last year when the stock price suffered a sizable decline.
Now, the market is underestimating the power of Amazon's online retail profits and full potential of its advertising business, Hancock says.
"People are pretty down on the retail part of Amazon," Hancock said. "You could almost explain its current valuation just with Amazon Web Services. (But) they have more growth engines."
Seeking Value, Too
When it comes to a quality company trading at an attractive market-level valuation, UnitedHealth fits the bill, Hancock says. "The stock trades at a (price-earnings) multiple that is perplexingly low if you think about the kind of growth it is able to generate and the strength of its business."
Last year, the health care giant grew revenue at a 12.7% clip to $324.2 billion, according to the company's quarterly earnings statements. And in the first two quarters of 2023, it has posted sales growth of 15% and 16%, respectively.
Hancock also likes drugmaker Eli Lilly, a stock he first bought in June 2019. It grew into a much larger position thanks to strong appreciation thanks to its drug pipeline, including its type-2 diabetes drug Mounjaro. Eli Lilly is also seeking FDA approval of Mounjaro as a weight-loss drug to treat obesity. "They have a much higher growth trajectory ahead," Hancock said.
Finding AI Opportunities, Too
While Hancock says the fund doesn't own Nvidia due to its elevated valuation, it is gaining exposure to the AI market more cheaply and indirectly via so-called "picks and shovels" stocks. These stocks — which include semiconductor equipment makers such as LAM Research and KLA and chipmaker Taiwan Semiconductor — provide the technology needed for AI to flourish.
"You can get growth at a lower price," said Hancock. "We feel like we can play the AI ecosystem through (these other stocks)."
Another indirect tech play is Accenture. The information-technology consulting firm, Hancock says, is under a cloud. Some fear its business model will be replaced by AI robots. But what investors are missing, he says, is that the core of Accenture's business is identifying what new technologies emerging from Silicon Valley can and should be deployed by their clients. "The more of these new technologies we have, the better it is for Accenture's business," Hancock said.
Another non-U.S. company Hancock likes is France's Safran. The maker of aircraft and defense equipment benefits from profits derived from servicing aircraft as well as a continued rebound in travel-related aerospace demand, Hancock says.
"There's strong upside on the revenue side," Hancock said. "Safran has a very strong annuity-like business servicing jet engines."
