As Market Shifts, It’s Time to Give Value Funds a Closer Look
Is market leadership finally changing? It certainly seems that way. Or, at least, it seemed that way at the start of last week, as the market’s underclass--beaten-down industrials and other so-called value stocks--staged a violent coup against the bull market’s elites: large “growth” stocks.
Given the end-of-the-week rally in big growth stocks, though, was it all just a giant head-fake?
It’s hard to say, says Jim Stratton, manager of the $59-million Stratton Growth fund, because “the psychology of the market is so mercurial.”
But one thing’s for sure: Whether or not growth stocks (shares of companies with rapidly expanding earnings and high price-to-earnings ratios) end up beating value stocks (overlooked or beaten-down stocks that are considered bargains relative to the companies’ underlying earnings or assets) for yet another year, the disparity between the two is likely to narrow. At the very least, conditions are ripe for value stocks to be competitive in the near term. Which means several things for investors:
For starters, we should no longer expect large growth-stock funds such as the Janus fund or White Oak Growth Stock fund to double our money in less than three years.
We’ll have to start caring more about whether our value funds are actually holding value stocks. (Several value funds, for instance, currently have big positions in growth stocks, such as America Online, Microsoft and Cisco Systems. Of course, in recent years, many of us have been only too happy with our returns to be concerned if our value managers were investing in growth stocks to boost their performance.)
In short, we’ll have to rediscover the virtues of value investing. Historically, one style of investing has rarely led the other for more than three years without at least a one-year turn for the other. Value hasn’t beaten growth since 1993, and last year, growth stocks gained more than three times as much as value. For the year to date, though, blue-chip value stocks are beating growth stocks. (In light of these facts, this may be the time to re-balance our portfolios, given the tremendous gains that our growth funds have delivered in recent years, vis-a-vis value).
Wall Street analysts and money managers generally cite a couple of reasons for the recent strength in value stocks.
For starters, there are growing signs that Asia is coming out of its recent economic downturn. This coupled with the surprising growth in consumer spending here at home means it’s far less likely that the U.S. economy will slip into a recession any time soon.
In fact, some believe the global economy is entering into a new phase of expansion. Notes Ron Muhlenkamp, manager of the $176-million value-oriented Muhlenkamp fund: “If you believe in the business cycle, we’ve just gone through a classic business cycle internationally and have just begun a new one.”
If so, it would bode well not only for many industrial cyclical stocks such as auto makers, but also for many of the commodity companies that supply industrial output, such as makers of steel, paper or chemicals.
All of these are traditional value sectors.
Since the end of March, the Standard & Poor’s 500/Barra Value stock index has jumped 8%, versus a rise of 3.4% for the S&P; 500/Barra Growth stock index. This is all the more remarkable given the fact that as recently as the end of March, growth had been leading value by more than 4 percentage points year-to-date.
Investors have seen a 9-percentage-point swing in about three weeks, says Nick Whitridge, veteran manager of the $1.2-billion Babson Value fund. “I haven’t seen anything close to the suddenness of this reversal in my career.”
But isn’t economic growth a good thing for growth stocks too?
Absolutely. But we’re talking comparatively here. In times of economic prosperity, it’s easy to find companies whose earnings are growing. In other words, when earnings growth is plentiful, it’s no longer special, and investors are less willing to pay a premium for it.
Plus, the improved outlook for Asia could put a stronger-than-expected wind at the domestic economy’s back. This in addition to rising commodity prices and Asia’s recovery are likely to renew concerns that the Federal Reserve could soon raise short-term interest rates, to keep inflation down.
Obviously, if that should occur, all equities would be adversely affected. But it would probably be worse for growth stocks, since growth-stock prices have been driven up to such lofty valuations in recent years.
As Stratton puts it: “Any Fed action [to raise rates] would take the steam out of the market, and there’s more steam in growth than in value.”
Indeed, the disparity, as measured by the price-to-earnings ratio, in what investors have been willing to pay for large growth stocks vs. large value stocks has hit a 20-year high, according to Salomon Smith Barney.
“The valuations are so high that any news that would cast doubt on growth could have a significant impact,” said John Gunn, chief investment officer for San Francisco-based Dodge & Cox.
Of course, not everyone agrees on the rate question.
Nonetheless, the market is clearly concerned. This is reflected in the fact that while cyclical stocks have rallied more than 16% month-to-date, financials are up less than half as much.
Higher interest rates , of course, will disproportionately affect the profits of financial services companies, such as banks, brokerages and insurers.
It should be pointed out, though, that relative to other value sectors, financial stocks have done well in recent years, which may help explain their lagging gain for April. But the tepid performance of financial stocks could also be a sign that the market is anticipating a rate hike, said Robert Boyd, manager of the value-oriented UAM ICM Equity fund.
The problem, then, under this scenario, for value fund investors?
The typical large value fund currently has as much as a quarter of its holdings in financial stocks. This isn’t surprising, as financial stocks, including the discount brokerage Charles Schwab, until this month had been among the “growthiest” value stocks in recent years. (Some funds recently held more than two-thirds of their assets in financial stocks. The $5-billion Sequoia fund, in fact, recently held a stunning 94% of its equity assets in this one sector, according to fund tracker Morningstar of Chicago.) At the same time, the typical large value fund holds just 15% of its assets in industrial cyclical stocks.
This means that if you’re in search of a value fund, there’s a good chance that an otherwise attractive fund may not benefit much from a near-term rally in value stocks.
One strategy is to screen for value funds with a greater-than-average stake in industrial cyclical stocks and a less-than-average position in financial stocks.
We’ve done that for you, in the chart accompanying this column. From Morningstar’s universe of 999 value funds, we screened out all those with an under-weighting in industrial cyclicals and an over-weighting in the financials. We also screened out funds whose returns didn’t beat those of at least half their value peers over the last one and three years--which was difficult for value funds with small financial holdings to do.
Among those funds that made the list are the $52-billion Washington Mutual Investors, which favors giant dividend-paying stocks; American Century Equity Growth, which has an equal weighting in financial and industrial cyclical stocks; and Royce Total Return, which favors dividend-paying stocks that manager Chuck Royce believes are selling at a discount to what a private investor would pay for the underlying company.
Of course, there’s another concern for value fund investors. As mentioned earlier, many value funds today are investing in growth stocks to boost short-term returns. To avoid this trap, you can stick with those portfolios that have historically invested in stocks trading at deep discounts to their underlying earnings or assets. Among the most successful of such funds, shown in the accompanying table, are the $4-billion Dodge & Cox Stock fund, which seeks out stocks trading at a 60% discount to what the managers believe the underlying company is intrinsically worth, and Vanguard Value Index, a passively managed fund that sticks to stocks in the S&P; 500/Barra Value stock index.
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Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.
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True Value Funds
In recent years, many “value”-oriented stock funds have invested partly in growth stocks to boost returns. Listed below are 10 funds that have stayed true to value investing-owning stocks carrying lower-than-average price-to-earnings (P/E) and price-to-book value (P/B) ratios. (Book value measures a company’s net worth.) The funds, grouped by stock capitalization size, all have delivered above-average returns.
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1-year 3-yr. ret., Avg. P/E Avg. P/B Fund tot. ret. annualized ratio ratio Vanguard Windsor II +8.7% +25.5% 23.6 4.5 Kemper-Dreman +3.5 +22.5 24.0 3.5 High Return Equity Vanguard Value Index +9.8 +23.8 25.1 3.9 Clipper +11.0 +22.1 22.6 4.7 Dodge & Cox Stock +7.1 +20.9 26.8 2.9 Avg. large value fund +4.9 +19.9 26.1 5.0 Tweedy Browne +1.8 +21.9 20.7 3.2 American Value Muhlenkamp -8.0 +21.6 17.2 3.1 Amer. Cent. Eq. Inc. +3.2 +19.0 18.8 2.3 Avg. mid-cap value -6.3 +14.6 22.3 3.5 Royce Total Return -7.3 +13.6 16.3 1.9 Shadow Stock -16.4 +10.3 16.3 1.4 Avg. small-cap value -20.6 +9.4 17.4 2.2
Fund 800 number Vanguard Windsor II 662-7447 Kemper-Dreman 621-1048 High Return Equity Vanguard Value Index 662-7447 Clipper 776-5033 Dodge & Cox Stock 621-3979 Avg. large value fund Tweedy Browne 432-4789 American Value Muhlenkamp 860-3863 Amer. Cent. Eq. Inc. 345-2021 Avg. mid-cap value Royce Total Return 221-4268 Shadow Stock 422-2766 Avg. small-cap value
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Poised to Ride a Value Wave
The typical value stock fund has a big holding in financial stocks and a smaller stake in beaten-down “cyclical” shares. But if the recent rally in value stocks continues, many analysts say, the cyclicals will fare better than financials. Below are 10 funds that have larger-than-average stakes in cyclicals without overweighting financials. These funds have also beaten at least half of their peers over the last one and three years.
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1-year 3-yr. ret., Avg. P/E Avg. P/B Fund tot. ret. annualized ratio ratio Amer. Cen. Eq. Growth +9.6% +28.6% 25.9 7.3 Wash. Mutual Investors +10.8 +25.8 28.7 5.4 Excelsior Value A +7.0 +24.7 27.1 6.6 Fidelity Equity- +13.8 +23.3 30.0 6.9 Income II EquiTrust Blue Chip +12.0 +22.8 27.9 6.0 Avg. large value fund +4.9 +19.9 26.1 5.0 T. Rowe Price Value +7.3 +21.8 24.6 3.6 Harbor Value +3.9 +21.2 25.5 3.6 Homestead Value +2.5 +17.9 24.9 3.8 Avg. mid-cap value -6.3 +14.6 22.3 3.5 Wachovia Special Val. -12.9 +15.1 20.1 2.0 Eclipse Small Cap Val. -17.8 +17.2 17.1 2.2 Avg. small-cap value -20.6 +9.4 17.4 2.2
Fund 800 number Amer. Cen. Eq. Growth 345-2021 Wash. Mutual Investors 421-4120 Excelsior Value A 446-1012 Fidelity Equity- 544-8888 Income II EquiTrust Blue Chip 247-4170 Avg. large value fund T. Rowe Price Value 638-5660 Harbor Value 422-1050 Homestead Value 258-3030 Avg. mid-cap value Wachovia Special Val. 944-4414 Eclipse Small Cap Val. 872-2710 Avg. small-cap value
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Source: Morningstar Inc.
