Value: Down, But Not Out

Whenever investors proclaim the death of an investing strategy, it’s often a buy signal. During the first 11 months of the year, Bill Miller's Legg Mason Value (LMVTX) lost 58 percent, more than 20 percentage points behind the S&P 500, according to Morningstar

In a year of many disasters, some of the most stunning setbacks involved noted value funds. During the first 11 months of the year, Bill Miller's Legg Mason Value (LMVTX) lost 58 percent, more than 20 percentage points behind the S&P 500, according to Morningstar. Longleaf Partners (LLPFX) dropped 53.8 percent. Other funds that lost more than 40 percent included such notables as Dodge & Cox Stock (DODGX), Third Avenue Value (TAVFX) and Weitz Partners Value (WPLVX).

Observing the carnage, some publications suggested that value investing strategies no longer work. An April 2008 article titled “The Death Of Value Investing,” published in Institutional Investor, the respected trade magazine for investment bankers, dismissed the thinking of Benjamin Graham, Warren Buffett's teacher and co-author of the seminal work, Security Analysis.

Graham famously advised buying stocks that cost less than the value of their assets. That approach thrived in good times, but it failed under extreme circumstances, the magazine noted. Graham himself had suffered huge losses in the Great Depression, and his favorite kinds of stocks were doomed to sink in the current turmoil. “Value stocks tend to be found among smaller, more cyclical companies,” Institutional Investor opined. “When the hundred-year flood arrives, such stocks are likely to be hardest hit.”

Rumors Of Death Exaggerated?

But the concerns about value investing seem overdone. For starters, not all value managers have suffered equally in the past year. Avoiding the worst trouble spots, many funds outpaced the S&P 500 by wide margins.

In the past, value funds often outdid growth during downturns. This year the pattern repeated. During the first 11 months of 2008, large value funds lost 38.5 percent, while large growth dropped 42 percent.

Among the winners that boosted value's showing were portfolio managers specializing in high-quality companies with steady earnings. Such stocks proved resilient, as panicked investors sought safety in reliable businesses. One of the top value performers of the year was Yacktman Fund (YACKX). Portfolio manager Donald Yacktman held some rock-solid blue chips that had dipped temporarily into value territory, including Coca-Cola and Microsoft.

While Yacktman shined, many deep-value funds lagged. Big holdings in shaky businesses and financial stocks pulled down results. Consider DWS Dreman High Return Equity (KDHAX), which lost 46.6 percent. Before the bear market began, veteran manager David Dreman had compiled a sterling long-term record by focusing on troubled issues, including many stocks with single-digit price-earnings multiples. Last year that led him to load up on such collapsing financials as Washington Mutual and Freddie Mac.

Can Dreman outdo Yacktman in the next five years? Perhaps. In the past, Dreman has sometimes soared back from periods of underperformance. Still, many advisors may prefer value funds like Yacktman's — high-quality portfolios that can reassure nervous clients. “This is a time to underweight financials and emphasize high-quality dividend stocks,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Massachusetts that clears trades through Schwab Institutional.

Investors seeking a smooth ride should consider GAMCO Westwood Equity (WESWX), which has out-returned 99 percent of large value funds during the past five years. Portfolio manager Susan Byrne wants profitable companies that are reporting improving returns on equity.

A dedicated value investor, Byrne rarely takes stocks with price-earnings ratios of more than 20. That normally prevents the fund from buying blue-chip growth stocks. But prices have come down, and the fund now holds such familiar names as Wal-Mart and Johnson & Johnson. “Growth stocks have been punished so much that they have come into our value territory,” says Mark Freeman, a GAMCO portfolio manager.

Another fund that bought battered growth stocks is American Century Equity Income (TWEAX), which has outpaced 99 percent of large value funds during the past decade. The fund owns General Electric and Kraft — companies with solid balance sheets.

While American Century underweighted financials, it had a few high-quality names in the sector. A favorite holding is Chubb, the property insurer. “Chubb has not had investments in the troubled mortgage area, and that has helped the stock to be relatively steady,” says portfolio manager Phil Davidson.

Love The Dividend

Some of the most stable value funds focus on dividend stocks. Income-providing shares often excel during periods when capital gains are elusive. A cautious choice is Aim Diversified Dividend (LCEAX). Because it focuses on stocks with solid balance sheets, Aim avoided most banks and other troubled financials. “Our goal is to add value while taking less risk,” says portfolio manager Megan Walsh.

A big holding is Automatic Data Processing, which manages payrolls. With unemployment rising, the shares have suffered. But the company has plenty of cash and a rock-solid balance sheet, says Walsh.

Federated Equity Income (LEIFX) holds a mix of value stocks, including troubled companies and steady names with growing earnings. Each holding must have a dividend yield that is at least 80 percent of the S&P 500's yield. “Dividend value stocks tend to perform in line with the markets when stocks are going up, but dividend stocks massively outperform during bear markets,” says Federated portfolio manager John Nichol.

Nichol prefers stocks that sell for less than their average historical price-earnings multiples. Such unloved issues may have little downside risk. A favorite holding is Mattel, which has declined because of concerns about weak consumer spending. “Expectations for Mattel are too low,” Nichol says. “While the consumers will be spending less, toys will be the last place that they will cut.”

Another holding is Leggett & Platt, a maker of furniture and bedding. Earnings have been slipping, but Nichol says that the company has a strong balance sheet and has increased dividends. Management recently sold some weaker businesses, raising cash that should help prop up the shares during the recession. Sticking with unloved dividend payers has enabled Federated to outdo 94 percent of its competitors in the past year and beat the S&P 500 by a comfortable margin.

HARD TIMES

Value funds, on average, gave back a lot of their past gains in 2008. But these funds have held on to beat the market longer-term.

Fund Ticker Three-year Return Five-year Return % Category Rank Five-year Return Maximum Front-End Load
Aim Diversified Dividend A LCEAX -5.5 1.3 13% 5.5%
American Century Equity Income A TWEAX -2.1 2.7 4 5.75
Federated Equity Income A LEIFX -4.2 1.6 10 5.50
GAMCO Westwood Equity AAA WESWX -3.8 4.0 1 0
Yacktman YACKX -4.5 0.1 29 0
Source: Morningstar. Returns through 11/30/08
TAGS: Mutual Funds
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