Value Funds May Offer Safer Haven in Turbulent Market
Times of market turmoil are supposed to be times when Wall Street seeks shelter in so-called value stocks--overlooked or otherwise unloved stocks that are relatively cheap when compared with the average stock.
And in this year’s market pullback, value-oriented mutual funds have, in fact, turned out to be somewhat safer havens than their growth stock fund cousins.
Whether that will continue is an open question, but after five years in which value stocks have mostly taken a back seat to growth stocks such as richly valued Microsoft and drug giant Pfizer--many value fund managers believe their day should be arriving.
“It’s overdue,” said Jean-Marie Eveillard, the value-oriented manager of SoGen International Fund. “It’s long overdue.”
Just what is a “value” stock? Wall Street usually categorizes value and growth stocks according to two key measures:
* The price-to-earnings ratio (P/E), which is the stock’s price divided by the company’s most recent four quarters’ earnings per share, and
* The price-to-book-value ratio (P/B), which is the stock’s price divided by the company’s net asset value per share--that is, the value of the assets minus the company’s liabilities.
In theory, the lower a stock’s P/E and P/B, the lower the risk an investor takes in owning the shares, and the greater the potential for the stock’s “true” value to eventually be recognized by the market.
In the market decline so far this year, value stock mutual funds have indeed turned out to be lower-risk holdings than growth stock funds, at least on average:
According to mutual fund tracker Morningstar Inc. in Chicago, the average large-cap value fund has fallen 14% since blue-chip shares peaked July 17.
By contrast, the average large-cap growth fund has fallen 16.6%.
The same divergence holds true for small-stock funds, Morningstar figures show. The average small-cap value fund has fallen 25.4% since the Russell 2,000 small-stock index peaked April 21. The average small-cap growth fund, meanwhile, has lost 27.5%.
(All of these figures are total returns, which is price change plus dividends.)
This seems to prove Jim Stratton, president of Stratton Capital Management in Plymouth Meeting, Pa., correct. Notes Stratton: “Value managers tend to underperform in strong up markets and outperform in down markets.”
Still, value funds are trailing growth funds badly year-to-date. The average large-cap value fund is down 2.6% for the year, while the average large-cap growth fund is ahead 6.9%.
What many value investors would like to believe is that their stocks will outperform high-flying growth stocks for an extended period, as more investors turn nervous about paying lofty P/E and P/B ratios.
Yet three of the market sectors in which value managers, by their discipline, have been focused--financial stocks, real estate stocks and energy stocks--have been hammered this year, for different reasons.
In other words, arguably “cheap” value stocks got a lot cheaper.
This explains why some classic value funds, like Neuberger & Berman Focus--which has more than half of its assets invested in financial stocks--slid as much as they did recently.
What’s more, there’s no guarantee that other value funds, which often invest heavily in overlooked industrial stocks, won’t slide even further should the economy head into recession.
Richard Bernstein, market analyst at Merrill Lynch, argues that because corporate profit growth is slowing overall, many investors will be particularly wary of value stocks whose earnings may be most sensitive to economic swings.
“In times when earnings are hard to come by [such as now], investors are willing to pay a premium for companies that deliver consistent, predictable earnings growth,” argues Kim Goodwin, manager of the American Century-Twentieth Century Growth Fund.
And that favors the fortunes of growth stocks and thus growth funds, she argues.
Still, the better performance of value funds versus growth funds thus far in the market pullback encourages some value managers.
“Maybe investors are beginning to realize that if we’re going to be in a difficult or bearish market for some time, value exposes [them] to less risk than growth or momentum investing,” said Eveillard.
Exposure to Both Growth and Value
Robert Boyd, manager of the UAM ICM Equity value fund, argues that there’s something else working in favor of value managers these days: The market’s dive has put many top-quality blue-chip stocks on sale--shares that value managers couldn’t touch as recently as a month ago because they were too pricey.
Notes Boyd: “We haven’t felt this comfortable buying stocks since the fourth quarter of 1994.”
While growth investors often chase what’s hot, value managers see market downturns as opportunities to uncover true bargains.
That argument for value investing now seems even stronger within the small-cap universe, many experts say.
Even if value funds aren’t poised to rally right now, argues Luke Collins, director of KPMG Peat Marwick’s investment consulting practice, it still “makes sense to invest in value.”
Take away the last year and value stocks, going back to Dec. 31, 1974, have actually beaten growth stocks, delivering annualized returns of 17.7% versus 15.3% for growth.
Over the last 15 years, the average value fund that invests in large companies such as Ford Motor Co., which trades at just 2.4 times the company’s earnings per share, has delivered almost exactly the same returns as the typical growth fund--and with decidedly less volatility.
Rather than try to time the market periods in which either growth or value is ahead of the pack, financial planners argue that investors should be exposed to both value and growth stocks at all times.
The simplest way to ensure that your portfolio has exposure to both growth and value stocks is through an index fund, financial planners say.
Yet investors may want to manage this mix themselves. Why?
The best-performing value stocks, it can be argued, are those trading at the deepest discounts to market average P/E and P/B ratios.
In 1992, for example, University of Chicago professors Eugene Fama and Kenneth French concluded, in part, that stocks trading cheapest relative to their underlying company’s book value are likely to beat the market in the long run.
Last year, the newsletter Dow Theory Forecasts looked at the performance of U.S. blue-chip stocks based on their P/E ratios.
Measuring from Nov. 30, 1994, to May 31, 1997, stocks with P/Es that were below 7 at the start of the period appreciated, on average, 228%, the newsletter found. Stocks with P/Es of 7 to 10 advanced 100%. Stocks with the highest P/Es, meanwhile, gained just 58%.
(All of these figures are price appreciation alone.)
Unfortunately, index funds don’t necessarily expose investors to the deepest value stocks.
To help identify some true value stock funds, we asked Morningstar to show us two groups of value funds: first, those that have performed best, relative to their peers, over the last 10 years.
Second, we wanted to see which value funds now hold stocks with the lowest average P/E and P/B ratios (again compared with value-fund averages) even if the funds’ performance hasn’t been stellar in recent years.
We used both screens for large-cap and small-cap value funds alike.
The chart accompanying the story shows a mix of value funds that fit one or both screens.
Some investors may ask whether the average P/E and P/B ratios for the typical large-cap and small-cap value funds, as shown in the chart, still seem fairly expensive.
Historically, value stocks have been much cheaper. But these value funds still hold shares that are far cheaper than the market average.
For instance, while the P/B for the typical large value fund’s average holding is 3.8, the P/B for the Vanguard Index 500 fund, a proxy for the Standard & Poor’s 500 index, is a lofty 6.3.
The P/B ratio for the typical large growth fund is even higher--7.4.
A more detailed look at some of the funds on the list:
Large-Cap Value Funds
* Kemper-Dreman High Return Equity A (5.75% load; minimum initial investment: $1,000): Of the 25 best-performing large-cap value funds over the last 10 years, this $4-billion portfolio represents the deepest value, based on its average holding’s P/E ratio of 16.5.
Manager David Dreman isn’t only a good stock picker, he has a knack for finding promising stocks in beaten-down sectors.
To be sure, his recent bargain-hunting trips into the decimated energy sector have held back the fund’s short-term returns. But not by much: While the typical value fund has lost 3% over the last 12 months, this fund lost a little less than half as much. Over the last decade, Kemper-Dreman High Return Equity has lived up to its name, delivering annualized returns of 18.3%.
* Davis NY Venture A (4.75% load; minimum initial investment: $1,000): Nearly half of this $5.4- billion fund’s assets are invested in the financial sector. And the fund has paid dearly for it. Since the market peak of July 17, the fund has lost 17.4% versus the 13.8% decline in the S&P; 500.
But if history is any guide, the fund--now led by Chris Davis, who recently took over for his legendary father, Shelby--will use the opportunity to buy stocks it wanted but couldn’t afford because of its value approach.
Over the last decade, Davis NY Venture has generated annualized returns of 18.4%, despite being 20% less risky than its peers, according to Morningstar.
* Dodge & Cox Stock (no-load; initial minimum: $2,500): Patience is this $4.5-billion fund’s virtue.
Like most value funds, Dodge & Cox Stock seeks big companies with strong balance sheets--including those that have recently stumbled. But what distinguishes this fund from its peers is that it’s willing to wait, often as long as five years or more, for stocks to pick themselves up and turn things around.
For instance, while numerous funds were dumping IBM in the early 1990s, when the shares fell as much as 70% from their 1991 high, Dodge & Cox held on. Smart move.
Over the last 10 years, the fund has delivered annualized returns of 15%. Yet it ranks as the 11th-deepest value fund in Morningstar’s large-cap universe, based on its average holding’s low P/B of 2.5.
* UAM ICM Equity (no-load; minimum initial investment: $2,500): There’s little chance that this $40-billion fund will be able to match its returns in 1995, 1996 and 1997, when it delivered annual returns of 30.7%, 29.2% and 29.6%, respectively.
So far this year, the fund has lost a disappointing 13.5%. But lead manager Robert Boyd has taken some steps that are likely to boost returns and safety going forward.
For starters, Boyd reduced the fund’s stake in financial stocks earlier this year, just in time to guard against the sector’s meltdown. And he has used global economic woes to build up stakes in some tech companies that have seen their shares pummeled--shares that he couldn’t touch earlier due to his value discipline.
Boyd’s fund, which screens for highly profitable firms priced below the S&P; 500’s average P/E ratio, offers the overall deepest value in Morningstar’s universe.
Small-Cap Value Funds
* FAM Value (no-load; minimum initial investment: $2,000): Despite having more than half its assets in financial stocks recently, this $360-million fund has held up relatively well.
Over the last 12 months, FAM Value has generated returns of 1.7%, versus the 17.2% loss for the typical small-cap value fund.
You can attribute this, in part, to the fund’s disciplined approach to stock picking. Co-managers Thomas Putnam and Diane Van Buren will buy only highly profitable companies trading at least 25% less than what they think they’re “intrinsically” worth. The strategy has delivered annualized returns of 14.8% over the last decade, beating 94% of its peers.
* Shadow Stock (no-load; minimum initial investment: $2,500): This $50-million micro-cap fund was launched, in part, to prove the basic theories of University of Chicago professors French and Fama--that over the long run, smaller stocks that lurk in the “shadows” of Wall Street--and those that trade cheaply based on their P/B ratios--will generate the highest returns.
Thus far the experiment is working. Over the last three years, Shadow Stock, which invests in companies with market caps below $200 million and boasts a low 1.4 P/B ratio, has delivered annualized returns of 12.3%, while the benchmark Russell 2,000 index has advanced 6.7% a year.
* Gradison Opportunity Value (no-load; minimum initial investment: $1,000): Manager William Leugers relies on a computer model to sift through the universe of small-company stocks to find undervalued companies with strong prospects.
The quantitative approach helps keep the fund honest. If there aren’t true values out there, Gradison Opportunity won’t buy, as evidenced by its large 27% stake in cash. That cash provided a nice cushion for the fund over the last 12 months, limiting its losses.
It should also help the fund pick up nice bargains in the wake of the current small-stock bear market.
* Hotchkis & Wiley Small Cap (no-load; minimum initial investment: $10,000): While this $85-million fund ranks as one of the 25 best-performing small-cap value funds over the last decade, it has stumbled badly since the market peak--down 36% since April 21.
But co-manager David Green said the poor performance can be attributed to recent bargain-hunting activity. Green notes that Wall Street has a tendency to overreact to companies that stumble--especially during downturns in the market.
“Once the market is done overreacting, we make lots of money for holding [beaten-down] stocks,” he said. Over the last 10 years, the strategy has delivered annualized returns of 11.5%, versus 10.7% for the typical small-cap value fund.
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Searching for ‘True Value’
These large- and small-cap stock mutual funds are among the most “value”-oriented funds available today, as measured by the average price-to-earnings (P/E) ratios and price-to-book-value (P/B) ratios of the stocks they own. Most of these funds have also been among the better performers in their categories longer-term.
Large-Cap Value Funds
Kemper-Dreman High Ret. Equity A
Total return since July 17: -10.3%
YTD tot. ret.: -1.2%
5-yr. ann. ret.: 20.5%
10-yr. ann. ret.: 18.3%
P/E ratio: 16.5
P/B ratio: 3.5
800 number: 621-1048
*
Harris Ins Equity A
Total return since July 17: -17.0%
YTD tot. ret.: -3.5%
5-yr. ann. ret.: 17.0%
10-yr. ann. ret.: 15.5%
P/E ratio: 18.8
P/B ratio: 3.5
800 number: 982-8782
*
Davis NY Venture A
Total return since July 17: -17.4%
YTD tot. ret.: -4.8%
5-yr. ann. ret.: 16.7%
10-yr. ann. ret.: 18.4%
P/E ratio: 19.6
P/B ratio: 3.5
800 number: 279-0279
*
Oppenheimer Quest Value A
Total return since July 17: -14.9%
YTD tot. ret.: -1.8%
5-yr. ann. ret.: 16.6%
10-yr. ann. ret.: 14.9%
P/E ratio: 17.8
P/B ratio: 3.0
800 number: 525-7048
*
Dodge & Cox Stock
Total return since July 17: -14.7%
YTD tot. ret.: -6.5%
5-yr. ann. ret.: 15.9%
10-yr. ann. ret.: 15.0%
P/E ratio: 19.9
P/B ratio: 2.5
800 number: 621-3979
*
Goldman Sachs Growth & Income A
Total return since July 17: -16.7%
YTD tot. ret.: -11.6%
5-yr. ann. ret.: 15.8%
10-yr. ann. ret.: NA
P/E ratio: 12.5
P/B ratio: 2.3
800 number: 526-7384
*
Salomon Bros. Opportunity
Total return since July 17: -16.2%
YTD tot. ret.: -6.1%
5-yr. ann. ret.: 15.6%
10-yr. ann. ret.: 13.4%
P/E ratio: 15.9
P/B ratio: 2.4
800 number: 725-6666
*
Prudential Equity A
Total return since July 17: -15.5%
YTD tot. ret.: -3.1%
5-yr. ann. ret.: 14.8%
10-yr. ann. ret.: NA
P/E ratio: 19.5
P/B ratio: 2.4
800 number: 225-1852
*
UAM ICM Equity
Total return since July 17: -16.8%
YTD tot. ret.: -13.5%
5-yr. ann. ret.: 14.3%
10-yr. ann. ret.: NA
P/E ratio: 12.3
P/B ratio: 2.2
800 number: 638-7983
*
Neuberger & Berman Focus
Total return since July 17: -27.8%
YTD tot. ret.: -12.5%
5-yr. ann. ret.: 12.7%
10-yr. ann. ret.: 14.4%
P/E ratio: 15.6
P/B ratio: 2.6
800 number: 877-9700
*
Avg. large-cap value fund
Total return since July 17: -14.0%
YTD tot. ret.: -2.6%
5-yr. ann. ret.: 13.4%
10-yr. ann. ret.: 13.7%
P/E ratio: 20.3
P/B ratio: 3.8
Small-Cap Value Funds
Eclipse Equity
Total return since April 21: -21.0%
YTD tot. ret.: -8.6%
5-yr. ann. ret.: 13.6%
10-yr. ann. ret.: 13.0%
P/E ratio: 16.6
P/B ratio: 2.2
800 number: 872-2710
*
FAM Value
Total return since April 21: -16.8%
YTD tot. ret.: -7.9%
5-yr. ann. ret.: 12.7%
10-yr. ann. ret.: 14.8%
P/E ratio: 15.7
P/B ratio: 2.3
800 number: 932-3271
*
CornerCap Growth
Total return since April 21: -23.7%
YTD tot. ret.: -14.7%
5-yr. ann. ret.: 12.2%
10-yr. ann. ret.: 7.5%
P/E ratio: 15.4
P/B ratio: 2.2
800 number: 728-0670
*
Shadow Stock
Total return since April 21: -17.2%
YTD tot. ret.: -9.9%
5-yr. ann. ret.: 11.5%
10-yr. ann. ret.: 10.9%
P/E ratio: 15.7
P/B ratio: 1.4
800 number: 422-2766
*
Gradison Opportunity Value
Total return since April 21: -22.2%
YTD tot. ret.: -15.4%
5-yr. ann. ret.: 10.4%
10-yr. ann. ret.: 11.6%
P/E ratio: 14.4
P/B ratio: 2.0
800 number: 869-5999
*
Delaware Small Cap Value A
Total return since April 21: -23.3%
YTD tot. ret.: -17.1%
5-yr. ann. ret.: 10.4%
10-yr. ann. ret.: 14.5%
P/E ratio: 15.5
P/B ratio: 1.8
800 number: 523-4640
*
Wright Junior Blue Chip Equity
Total return since April 21: -21.7%
YTD tot. ret.: -15.2%
5-yr. ann. ret.: 9.4%
10-yr. ann. ret.: 9.1%
P/E ratio: 12.8
P/B ratio: 1.9
800 number: 888-9471
*
Winthrop Small Company Value A
Total return since April 21: -23.6%
YTD tot. ret.: -15.8%
5-yr. ann. ret.: 9.1%
10-yr. ann. ret.: 12.4%
P/E ratio: 15.1
P/B ratio: 2.1
800 number: 225-8011
*
Hotchkis & Wiley Small Cap
Total return since April 21: -35.5%
YTD tot. ret.: -24.4%
5-yr. ann. ret.: 8.1%
10-yr. ann. ret.: 11.5%
P/E ratio: 11.0
P/B ratio: 1.9
800 number: 346-7301
*
Avg. small-cap value fund
Total return since April 21: -25.4%
YTD tot. ret.: -16.2%
5-yr. ann. ret.: 9.9%
10-yr. ann. ret.: 10.7%
P/E ratio: 17.0
P/B ratio: 2.3
Note: All returns are through Friday.
Sources: Morningstar Inc., Bloomberg News
