This article originally appeared in Morningstar Direct Cloud and Morningstar Office Cloud.

Which funds managed to tough out category-topping performance during the last three years when value’s overall numbers were at their bleakest since the late 1990s?

In part one of this series we looked at the numbers on the value versus growth differential. In the second part, we tapped into Morningstar’s manager research team to learn about what they’ve been hearing from fund managers. In part three, we go back to the data to see which funds were the top performers and investigate what led to their outperformance. We will also provide some snippets of commentary from our analysts about funds that are Morningstar Medalists.

For this article, we created a simple screen in Morningstar Direct to provide a cross section of the winners. We gathered portfolios with less than $500 million in assets and ranked them by performance for the three years ended 31 August 2019.

One overarching theme emerged: Value funds that focused on higher-quality companies, rather than deep value or turnaround stories, tended to provide investors with better returns over the past three years. Similarly, strategies that focused on dividend-paying companies--which often are more stable, cash-producing enterprises--populated the ranks of the top performers.

We turned back to the performance-attribution tool available to Morningstar Direct clients at portfolioanalysis.morningstar.com to help illustrate the trend toward higher-quality stocks that were outperforming. We created a portfolio of the top-10 funds for the three-year time period and substituted the remaining funds in the category as the benchmark.

In the following image we drill into the winning funds by breaking down their portfolio holdings by Morningstar Economic Moat Ratings. Economic moat is a proxy for quality, representing the level of a company’s sustainable competitive advantage. Wide-moat companies are those deemed to have the most significant, sustainable competitive advantages.

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As shown by this sample, the top-10 funds held considerably more wide-moat stocks, and by looking at the active return data, the attribution analysis suggests that wide-moat stock emphasis was a major contributor to the group’s outperformance.

Here’s a look at the top performers broken down by market capitalization. In each group, we’re highlighting two of the funds that carry Morningstar Analyst Ratings along with some key points from the analyst commentary.

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Columbia Dividend Income

This fund's managers look for firms with sustainable cash flows that lead to steady, and sometimes increasing, dividend payments.

The team's cautious approach requires that holdings pay steady dividends from predictable, free cash flows. This bias to sturdier fare has helped the fund hold up better than its benchmark during market downturns.

The managers' ability to protect capital in down markets hasn't held it back too much in market rallies, though. The fund still captured 92% of its benchmark's gains in up markets over the same period.

Katie Rushkewicz Reichart, CFA, Aug. 27, 2019

Principal Equity Income

Straightforward screens whittle down the strategy’s investable universe. Managers Dan Coleman and Dave Simpson look for stocks with market caps greater than $10 billion at the time of purchase, dividend yields of 2.5 to 7.0 per cent, and payout ratios under 60 per cent. About 250-350 names pass these screens.

The strategy’s income orientation produces a modest yield. The portfolio’s 2.9 per cent average dividend yield in March 2019 edged the Russell 1000 Value benchmark’s 2.8 per cent. This decent but not awe-inspiring rate owes to the managers' openness to firms that it believes can grow dividends over time, such as Apple (AAPL), instead of chasing those with the highest current yields.

Tony Thomas, Ph.D., May 2, 2019

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Janus Henderson Mid-Cap Value

While the fund buys discounted fare, it doesn’t use a deep-value approach. The duo analyzes the potential for loss before considering possible gains and positions the roughly 60-stock portfolio in stable areas such as industrials. However, the strategy's price multiples are often in line with or higher than the Russell Mid-cap Value Index and mid-value Morningstar Category peers as its managers hold on to winners and will pay higher valuations for better-quality companies. Still, it pays heed to prices and it has been underweight utilities because of stretched valuations, which weighed on the strategy's 2018 result. Additionally, the strategy carries lower Morningstar risk ratings relative to peers, attributable to its managers' cautious approach.

The fund tends to post elevated price metrics versus its index and peers, reflective of management's preference to hold winners, even when valuations become stretched. But it also sports better profitability metrics like returns on assets, returns on equity, and returns on invested capital.

Christopher Franz, CFA, March 12, 2019

Victory Sycamore Established Value

The group singles out profitable mid-cap companies with strong prospects that are valued with a margin of safety. It carefully assesses company balance sheets and management allocation of capital to help mitigate downside risk. Accordingly, the roughly 70-stock portfolio boasts better profitability metrics and lower aggregate debt levels than the Russell Mid-Cap Value Index and most mid-value peers. Relative to its benchmark and peer-group norm, the strategy has long featured a technology overweight. That overweight, combined with the group’s penchant for holding winners, often leads the portfolio to trade at a premium.

The group searches for companies with sustainable business models that trade with a margin of safety yet possess catalysts for a positive change. Such positive changes include new product cycles, margin or cyclical earnings recovery, or restructuring. Evaluating downside risk is integral to the team’s research, so it pays careful attention to company balance sheets and cash flow generation, as well as management’s utilisation of capital, as it believes investing in higher-quality businesses helps protect against downside risk.

Christopher Franz, CFA, April 22, 2019

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Taking a quick dive below the surface of the small-value winners using the performance-attribution tool, we can see how the portfolio of top-performing funds stacked up against the rest of the small-value category at the industry group level. The performance-attribution data suggests that an underweighting toward energy stocks was a key contributor to the outperformance.

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Janus Henderson Small Cap Value

Perkins' value-conscious investment approach spans the shop's lineup, but this isn't a deep-value fund. The managers don't buy stocks just because they look cheap; they analyze the potential for loss before considering possible gains. Portfolio candidates must have strong free cash flows, reasonable debt levels, and healthy balance sheets. This risk-conscious approach has protected capital better than peers and the benchmark in down markets, therefore resulting in lower volatility.

The fund has courted more price risk than its index and average small-value peer, attributable in part to its managers' preference to hold on to winners, even when valuations may become stretched. Still, the fund boasts higher-quality metrics, such as lower aggregate debt levels and higher margins than its index, as well as superior returns on assets, returns on equity, and cash flow, indicative of the profitability types of companies the managers seek.

Christopher Franz, CFA

Royce opportunity

The deep-value approach focuses on a mix of micro- and small-cap stocks that are cheap relative to their assets, and undervalued for their growth prospects, turnaround stories, or hitting earnings turbulence.

Manager Bill Hench takes an orderly approach to deep-value, small-cap investing. He focuses on stocks with up to $3 billion in market capitalization, though most holdings are considerably smaller. Each holding falls into one of four buckets: stocks that look cheap relative to their assets; stocks with undervalued growth prospects; turnaround stories; or stocks suffering earnings disruptions. The last two are similar but still distinct. Turnaround stories are recovering from poor operating performance and often involve management changes. Companies with interrupted earnings tend to have strong growth potential but weak valuations because of what Hench and his team see as short-term problems. To qualify for inclusion, stocks must look cheap relative to book value and sales.

Tony Thomas, Ph.D., March 10, 2019

Where does value go next?

Of course, it’s impossible to draw any conclusions from just one month, but September did bring a reprieve to long-suffering value investors. A look at the month’s returns showed a reversal of fortunes within the large-value category, with funds that have lagged significantly in recent years, such as Transamerica Large Cap Value (TWQZX), popping up into the top quintile of the category. And some funds that had been stuck in the middle of the pack, such as Hotchkis & Wiley Large Cap Value (HWLIX), Vanguard Windsor (VWNDX), and Invesco Comstock (ACSTX), also experienced strong returns in September.

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