As Interest Rates Climb, Investors May Take a Fresh Look at Value Funds

Conventional wisdom tells us that rising interest rates are bad for the stock market.

It’s easy to see why.

When interest rates rise--as the yield on the benchmark 30-year Treasury bond did last week--bonds and cash become more attractive alternatives to the stock market.

And the stock market hates competition. We saw this late last week as the Dow Jones industrial average gave back nearly 250 points in response to rising bond yields.

Conventional wisdom also tells us that rising rates are particularly bad for so-called value stocks--shares of companies the market has overlooked or beaten down for whatever reason.

Again, it’s easy to see why. At least at first blush.

Value stocks--which have lagged growth stocks badly during most of the 1990s bull market, especially last year--are often associated with certain industries, namely the financial services sector (think banks and insurers) and industrial cyclicals (auto makers, for instance).

These are the very industries that are most vulnerable to interest rate spikes. After all, rising rates curtail economic growth, which hurts banks. (And they make it more expensive for us to take out consumer loans--to buy a car, for instance.)

Notes David Schafer, manager of the Strong Schafer Value fund: “If rates go up, generally speaking, there would be an adverse reaction to insurance companies, banks, consumer credit companies, and housing and auto sales.”

Yet this environment of rising rates--the yield on 30-year Treasuries has shot up half a percentage point since the end of January to 5.58%--may be just the right time to rediscover overlooked value stocks and value stock funds, several Wall Street analysts and money managers argue.

The argument goes something like this:

When investors buy growth stocks (shares of companies with rapidly growing earnings), they are paying for earnings acceleration or potential, not the actual earnings.

Indeed, some of the highest-flying growth stocks in the Standard & Poor’s 500 index of blue-chip stocks only recently turned a profit. America Online, for instance, went from losing money in 1997 to posting a meager profit of 11 cents a share last year. Lucent Technologies is another example.

Now, when real interest rates rise, earnings potential becomes less important than the earnings themselves.

Why? Put simply, interest rates are the cost of capital--in other words, a measure of how valuable money is. The higher rates are today, the more valuable money is today. So “in a rising-interest-rate environment, earnings today are worth more compared with possible earnings tomorrow,” notes Edward Keon, director of quantitative research at Prudential Securities in New York.

Also, rising rates increase borrowing costs, which could have a disproportionate effect on the profits of fast-growing companies.

Logically, this should take attention away from growth stocks and refocus it on value.

Argues Keon: “Value managers will be back in the game. There should be a much closer competition between value and growth going forward.”

To be sure, this is all a relative argument. That is to say, if rates stay high for a long time, all stocks will suffer. And Keon and others are not saying that value stocks will generate eye-popping returns. But rising rates, provided they don’t rise too high too fast, could help value regain its footing vis-a-vis growth, argues Chris Orndorff, head of equities for the Los Angeles-based money management firm Payden & Rygel.

Over the last decade--a period characterized by falling rates--the average mutual fund that invests in large growth stocks has gained an annualized 18.5%. At the same time, the average large value stock fund is up just 15% annualized.

But in 1993, when rates began to rise temporarily, the typical large value stock fund gained more than the average large growth fund. And the next year, when rates continued to rise and stocks generally lost money, these value funds lost less than the typical growth fund.

In recent weeks, Robert Boyd, manager of the UAM ICM Equity fund, says he has sensed that “the market is broadening out from a value perspective.”

Not a lot. But enough to be promising. Although growth stocks are still leading value stocks so far this year, the S&P; 500/Barra value index has lost about half as much ground as the S&P;/Barra growth index so far this month.

Some promising value stock funds to consider:

* Vanguard Growth & Income (no load; minimum initial investment: $3,000; three-year annualized return: 25.6%; [800] 662-7447).

* American Century Equity Growth (no load; minimum initial investment: $2,500; three-year annualized return: 25.6%; [800] 345-2021).

* Muhlenkamp (no load; minimum initial investment: $200; three-year annualized return: 18.3%; [800] 860-3863).

* Weitz Value (no load; minimum initial investment: $25,000; three-year annualized return: 26.8%; [800] 232-4161).

* Tweedy Browne American Value (no load; minimum initial investment: $2,500; three-year annualized return: 19.4%; [800] 432-4789).

All these funds have beaten at least 80% of their respective peers over the last one, three and five years.

Now the bad news.

Although rising rates may signal the return of one out-of-favor sector, they could mean more troubles for another: small-company stocks.

According to a recent study by Morgan Stanley Dean Witter, rising rates tend to hurt net new investments into stock mutual funds. Once again, this is in part because rising rates make bonds and cash a more attractive alternative to stock funds. On average, a 1-percentage-point increase in 30-year T-bonds corresponds to a $2.6-billion decline in monthly flows, said Morgan Stanley equity analyst Leah Modigliani.

Since large-company stock funds have gotten the lion’s share of net new mutual fund investments lately, high rates could dry up what little money is flowing into small-company stock funds.

This should make an illiquid sector that much less liquid.

“Yeah, there’s not much good news for small caps here,” said Thomas McDowell, co-manager of the UAM Rice Hall James Small Cap Portfolio.

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.