Though past performance is not indicative of future results, the decade-long exceptional track record of the GMO Quality Fund — a top winner in Investor's Business Daily's 2024 Best Mutual Funds Awards — deserves some special attention.
The GMO Quality IV Fund, (GQEFX) is among the top five funds in each of our Best Mutual Funds categories for Best U.S. Diversified Stock Funds, Best Blend Funds, and Best Large-Cap Funds.
The GMO Quality IV Fund, one of several shares classes in the GMO Quality family, has outperformed the Standard & Poor 500 index over the past one-, three-, five- and 10-year periods. Given that performance, Morningstar gives the Large Blend fund a five-star gold medalist rating.
"A sound investment process and strong management team underpin GMO Quality IV's Morningstar Medalist Rating of Gold," wrote Morningstar in its most recent assessment of the fund.
Mutual Funds With A 10-Year Track Record
In IBD's ninth annual list of the best mutual funds, 587 funds made the cut out of roughly 7,500 funds. That's up from 488 last year. Among funds at least 10 years old, that's a feat only 16% of the eligible funds can claim.
This year's Best Mutual Funds Awards used the same selection criteria as prior years. Funds must have a 10-year track record. And our winners' list only includes funds that topped their benchmark indexes in the past one-, three-, five- and 10-year periods ended Dec. 31, 2023. That multiyear outperformance shows that the winners in Investor's Business Daily's Best Mutual Funds 2024 Awards are funds that top their benchmarks consistently over the long term.
Quality At A Reasonable Price
So what does Tom Hancock, the head of focused equity at GMO, say are the key factors behind the GMO Quality Fund's success?
In a recent interview, Hancock said the success of the GMO Quality Fund, which Hancock manages along with Ty Cobb and Anthony Hene, stems from a commitment to high-quality stocks, coupled with a keen focus on reasonable valuations.
"It's quality at a reasonable price," he said. "So in terms of the consistency of performance, I think that's been very important."
What's more, this approach worked especially well in down markets, such as that in 2022.
Buying high-quality stocks would typically be an effective strategy during a bear market.
But that assumption might not always hold true if you don't consider the price you're paying for these stocks.
And that focus on investing in quality stocks at a reasonable price has "definitely helped the fund on the downside," Hancock noted. But conversely, "on the upside, we've been able to participate in some of those strong markets," he added.
The fund's team believes that high-quality companies with established track records of profitability and strong fundamentals can outgrow the average company over time and are worth a premium price. "We are willing to pay a premium for growth and profitable growth," he noted.
Read More In Our Full Special Report, Learn How The Best Funds Beat Their Benchmark, And See The Top Funds In Every Category
The fund invests in both high-quality, growth-oriented technology firms as well as health care and consumer staples stocks, sectors traditionally seen as more conservative. "And being able to rebalance between them is pretty important for us," he said.
He said the managers successfully adjusted their focus by moving away from growth stocks when they were overperforming in late 2021, and then re-establishing positions in them near the end of 2022. This shift, Hancock noted, was driven by valuation and rebalancing considerations. "We weren't swinging for the fences," he said.
The Metrics: High Returns On Investment
So, what measures do Hancock and his team use to determine whether a stock is quality or not? Is it price-to-book, return on equity, price/earnings-to-growth or free cash flow?
The overarching theme in terms of quality is to identify companies capable of reinvesting capital at substantial rates of return for the future, said Hancock. "And so as a result of that, (they) deserve higher multiples," he said.
Initially, as a value-oriented firm, GMO recognized that the firm was overlooking these types of companies and understood the need to be open to paying more for them, he said.
What allows a company to achieve this? They need the chance to grow and reinvest, but they also require a defensive strategy to ward off competition, coupled with effective management that knows when to invest capital and when to return it.
Hancock said the GMO Quality Fund team applies backward-looking screening with forward-looking fundamental analysis. The team looks for companies with a proven track record of high returns on investment — return on equity, return on assets and gross margins. "We want it to be high," he said. "We also want it to be consistent. So, stable across the cycle. And we also want to see a strong balance sheet."
Hancock said it would be fair to categorize the fund as neither growth nor value but core. That's reflected in terms of the aggregate characteristics and the individual holdings. "Most of the individual holdings are kind of core-type stocks," he said. "You won't find many stocks in our portfolio with single-digit P-E ratios, and while we do have some stocks with P-E ratios over 30, they don't make up the majority of our holdings."
The Top 10 Holdings
As of January 2024, the fund's top 10 investments included Microsoft, UnitedHealth Group, Alphabet, Meta Platforms, and Amazon. Additionally, it held positions in the GMO U.S. Treasury Fund, Johnson & Johnson, Safran S.A. Apple, and Accenture.
Hancock noted that the fund invests in five out of the Magnificent Seven companies, and UnitedHealth is the fund's second-largest holding after Microsoft. These companies, while varied, share a common trait of having strong, entrenched market positions, he said.
Microsoft is embedded in the IT departments of virtually every company around the world and "you don't have to bet on a specific technology for Microsoft to win," he said. Hancock noted that Microsoft tends not to invent new technologies (AI being a recent exception). Rather, it excels in monetizing them.
UnitedHealth, beyond being a health insurance provider, offers a broad range of health care services. Its scale allows it to negotiate lower costs with providers, offering competitively priced services, he noted. (Hancock spoke to Investor's Business Daily before news that UnitedHealth is facing a U.S. antitrust probe.)
For Apple, Hancock said the focus shifts slightly toward brand strength and the company's ecosystem. Once users are integrated into Apple's ecosystem, it's challenging for them to switch away. And this creates strong brand loyalty and network effects, he said.
In Alphabet's case, Hancock said the widespread use of Google search enhances its quality, making it difficult for competitors to match. "The fact that everybody uses Google search is what makes Google search better than anywhere else's search," he said. "So that kind of thing is hard to displace."
Quality Plus Valuation
All that speaks to the quality of the business in terms of owning the stock, Hancock noted. "The other piece is the valuation," he said.
For instance, Hancock said Nvidia is a high-quality company (it is not among the fund's holdings), but the GMO Quality Fund team's focus is more on stock valuation. Nvidia's P-E ratio was 63 as of March 2.
Alphabet had a P-E ratio of 24 as of the same date, Meta had a P-E ratio of 32 and UnitedHealth was at 19. "There's always a little bit of political overhang that keeps the multiples down below what the fundamentals seem to justify," said Hancock.
As for Amazon, it appears expensive with a P-E ratio of 61. But that's partly due to accounting practices where much of its investment is classified as expenses, Hancock said. Those investments, however, are for future growth, which the company historically managed well. "So when we adjust to that, we don't actually see them as that expensive," he said.
The Benefit Of A Concentrated Approach
Altogether, the GMO Quality Fund's portfolio comprised 41 stocks at the end of January and the top 10 holdings were 38% of the fund's assets under management. What's the benefit of this concentrated approach?
In the fund team's search for outstanding companies at fair prices, even with a global search, they find that the options are limited. "We couldn't come up with a hundred stocks that met our portfolio's (criteria)," Hancock said.
As for potential drawbacks such as high volatility or risk due to concentration, Hancock said it depends on the types of stocks in the portfolio. Since the fund invests in well-established companies with diverse operations, he considers the fund to be relatively low risk. Historical data on volatility and tracking errors, Hancock noted, have not been high. "So the evidence supports that view," he said.
Potential Portfolio Risks
What about risks that could affect the companies owned in the portfolio, such as inflation or a recession? "There are risks that affect every company and so a recession would be that, right?" he said. "No one wins."
He noted that companies that prioritize environmental quality generally fare slightly better in such situations compared to others. But the fund's holdings include fewer cyclical stocks than the broad market.
Inflation is another challenging factor for all, but high-quality companies usually have stronger pricing power and often benefit from lower costs in terms of commodities, labor and other inputs, he said. And this gives them a relative advantage in tough times.
Hancock did express concern about geopolitical issues, the one factor that could keep him "up a little bit more at night." His worry stems from the fact that high-quality companies often operate as multinational and thus are vulnerable to global tensions. "If you're a great business with a great business model, you're likely to operate around the world," he said. That's "certainly true of where you're selling your product."
These companies are also global in their supply chains. They've been smart in optimizing this aspect of their business, but what's considered optimal now differs from what it was two decades ago, Hancock said. And companies are adjusting to these changes.
Market Valuations For Companies In The Portfolio
Hancock also addressed the topic of market valuations for some of the companies within the portfolio, examining the challenges they might face in achieving growth from an already substantial base.
He has reservations about certain companies the fund doesn't own. On the other hand, he's quite confident in the stocks the fund holds.
He recalled a colleague pointing out a decade ago how rare it is for the largest stock in the market to outperform. Yet considering Apple's example, it's evident that perceptions have changed. A few decades back, the idea of companies reaching multitrillion-dollar market caps seemed far-fetched. But internet and tech business models have shifted the landscape toward a more winner-takes-all scenario.
"I don't think Nestle could grow in the kind of way that Microsoft or Apple or maybe Nvidia or Alphabet can," he said. "Of course, there is a limit, though. Every dollar of growth is less meaningful the bigger you are. So you can't expect to escape the math of that."
Changes to the Portfolio
Does Hancock anticipate making any changes to the GMO Quality Fund portfolio given the current macroeconomic environment and current market dynamics?
"We do react to valuations," he said, noting the fund will swing between growth and value. "And we are more in the mode of trimming some of our tech winners and adding to some of … our more conservative positions."
Think health care and consumer staples. Those sectors have underperformed significantly over the past year, not only because they lack the allure of "fancy AI stocks." It's also due to the negative impact of rising interest rates, especially since they're often considered alternatives to bonds. As a result, Hancock's team has been more cautious in the fund's investments in this area of the portfolio, with decisions heavily influenced by the available opportunities.
As for using AI in the management of the portfolio, Hancock noted that "we're light users" of AI for things such as generating code. "We do a fair amount of quantitative-type work," he said. "So generating code, analyzing documents, just basic level you might say, Google search-type functionality. So we're users of it, but it's not a game changing thing for us."
The Seven-Year Outlook
Hancock also addressed how his team manages the fund considering GMO's seven-year outlook. GMO is forecasting a real return of negative 3.5% for U.S. large-cap stocks over the next seven years.
"GMO is a firm made up of smaller investment teams that match their portfolios independently," he said. "And while I think we have a lot of the same DNA and think the same way, we don't necessarily have all the same views. The seven-year forecasts don't actually feed into our investment process and affect what we do. We're more bottom-up stock pickers."
When it comes to the stocks the GMO Quality Fund invests in, Hancock is confident that they have the potential to generate double-digit returns through fundamental growth, including earnings growth and dividend yield.
He believes the stocks in the portfolio aren't valued at such high multiples that any growth would be negated by a contraction in those multiples. "So, we feel quite good about our portfolio, which, as you mentioned, comprises 40 stocks, and is distinct from the broader S&P 500."
Ultimately "if you're worried about the market and you have to invest in stocks or you're not so worried that you want to get out of the market completely, high-quality companies are a great place to hide," Hancock noted.
The GMO Quality Fund has six share classes. Each share class represents investments in the same mutual fund portfolio. Share classes differ in how and when investors can pay for fund distribution costs, as well as the ongoing fees and expenses.
What the Future Holds For GMO Quality Fund
Does the fund's long-term track record put pressure on the team to keep it up?
"I'd say pressure maybe isn't the word I've used," Hancock said. "The thing you always have to guard against is complacency. I'd like to think that we have a pretty good culture of challenging ourselves and not letting our heads get too big. And while we've had a very good run, I have been at GMO for 25 years, and I have some personal experience of things being less than good."
Hancock noted that the quality strategy had a "pretty rough start out in the gate." The fund started in 2004 "and it really took until the financial crisis for the strategy to kind of prove its worth."
"So we have long enough memories that hopefully it hasn't gone to our heads," he said.
