More Are Letting Market Dogs Dig for Deep Value

An investor’s best shot at earning above-average future returns on stocks is to buy those issues that are most out of favor today.

That’s one approach that has gained favor in recent years, even with “efficient market “ theorists who used to argue that the market simply couldn’t be beat in the long run.

Santa Monica-based Dimensional Fund Advisors, which manages $17 billion in index funds mainly for institutional clients, has been pitching the “buy the dogs” thesis since 1992 and has already attracted nearly $5 billion in client funds into various index funds that take that approach.

Rex Sinquefield, a principal at DFA, says academic research has confirmed the tendency of “deep value” stocks to outperform the market average over time. Although Sinquefield is an efficient-market true believer, he reconciles the dog stocks’ higher returns like so: “We agree the extra return is there, but we’re saying that’s because there’s extra risk” in those stocks.

The market is still efficient, he says, because the higher risk entailed in getting higher returns assures “you don’t get something for nothing.”

DFA’s judgment of which shares are most out of favor, and thus the deepest values, is based on stock price relative to the underlying value of a company’s assets (the “book” value). DFA’s value index funds can own only the 30% of stocks that sell for the lowest prices relative to book value.

As the stocks rise to a higher price-to-book level, they are sold in favor of new dogs.

Of course, the idea of buying what’s out of favor--betting on an eventual rebound--has long been preached on Wall Street as a smarter strategy than buying what is already flying high. But in practice, Sinquefield says, many institutional investors can’t bring themselves to do it. “They just don’t want to hold a portfolio of dogs. But we will,” he says.

DFA has separate value index funds for large stocks, small stocks and foreign stocks. Individual investors, however, can get into the funds only via financial planners.

Vanguard Group also offers a value index fund, encompassing the Standard & Poor’s 500-index stocks with the lowest prices relative to book value.

Still, investors should note that the deep-value index concept is fairly new in actual practice. Also, there are plenty of active fund managers who focus exclusively on value stocks, some quite successfully.