Increasingly, Value Is in Beholder’s Eye
Is there room in the new economy for old-style “value” investing?
That question is bedeviling a large segment of the mutual fund industry, after a third-quarter plunge in many so-called value stocks ended what had been a promising turnaround for that sector in the second quarter of 1999.
In the third quarter, the average fund that invests in large-capitalization value stocks slid nearly 10%. That was almost three times the loss suffered by the average fund that invests in large growth stocks.
Many individual investors in mutual funds might have paid little attention to the differences between value and growth stocks in recent years. Many may not even know to which camp their stock funds belong.
But the performance of value-oriented funds has mostly been so miserable since 1997 that more investors in those funds have at least begun to ask what’s wrong.
Value isn’t a minor fund industry subset: Indeed, fund tracker Lipper Inc. calculates that assets in value-oriented general stock funds total $660 billion, versus $739 billion in growth-oriented general funds.
Traditionally, value stocks have been defined as beaten-down or overlooked shares that are “cheap” on some relative basis--for example, those with low price-to-earnings ratios or low price-to-book value ratios (share price compared with the company’s underlying asset value per share).
Often these companies are in slower-growing mature industries, or have temporarily fallen on hard times.
Growth stocks, by contrast, are shares of companies that typically boast the highest earnings growth rates. By definition, then, they usually are in the hottest industries. And because their growth expectations are so high, these stocks tend to sell for very high price-to-earnings ratios.
Though it might seem that investors would always favor growth stocks, in fact the market’s preference fluctuates. In times of rising interest rates and rising market risk, growth stocks can fall out of favor.
On the flip side, when investors collectively decide that it makes more sense to bargain-hunt, value stocks can dominate the action.
In the second quarter, value stocks roared back to life. But the fast reversal in the third quarter--while growth stocks either gained or held up reasonably well--suggests the value rebound was a flash in the pan.
The problems of the value sector have fueled some new thinking on Wall Street since at least 1997.
One idea is that in this increasingly technology-dominated age, old-school value stocks (especially in mature industries) simply can’t compete with growth stocks for investors’ attention.
Notes Charles Mayer, director of investments for the Invesco funds and manager of the $4.8-billion Invesco Equity Income fund: “Individual investors have embraced growth and believe that growth, not value, is the avenue to take.”
Another idea is that value investing remains a workable discipline--if you’re willing to bend the rules for determining what constitutes a value stock in this era.
The fact that value fund managers have split into two camps--old-style and new-era--shows up in third-quarter value fund returns.
“If you look at the numbers, they’re all over the lot,” says David Schafer, manager of the $850-million Strong Schafer Value fund.
While some value funds lost as much as a fifth of their value in the third quarter, others, such as American Century Equity Growth, came out relatively unscathed. This, even though the latter fund recently held nearly 20% of its assets in financial stocks, a traditional value sector that got slammed this year as interest rates rose.
Year to date, dozens of other value funds, led by Smith Barney Fundamental Value, are putting up numbers that are beating the Standard & Poor’s 500 index.
“Whose ox was gored really depended on how they [funds] define value,” says Schafer, an old-style value investor whose fund is down 22% this year.
For instance, can a stock such as Intel, trading at a P/E ratio of 35 based on trailing 12-month earnings per share, be considered a value play? At least 114 value-oriented stock funds seem to think so.
What about America Online, with a stratospheric P/E of 292? Ask Bill Miller, manager of the $10.7-billion Legg Mason Value fund, which recently held more than 11% of its assets in the Internet giant.
While purists might cringe, a growing legion of value fund managers contends that relatively high-P/E tech, telecommunications and, in some cases, even Internet stocks can be considered value plays--provided they exhibit other favorable value characteristics.
Perhaps the best example is Legg Mason’s Miller, whose large-cap value fund is up about 7% year to date, which is competitive with many large growth stock funds.
With a portfolio whose top three holdings consisted recently of AOL and computer makers Dell Computer and Gateway, Miller has finished in the top 1% of his value peers over the last one, three, five and 10 years.
A common trait of all value investors is the desire to buy stocks at prices that are less than the company’s “intrinsic” worth.
Of course, as Robert Rodriguez, manager of the $555-million FPA Capital fund, notes, “How many money managers of any kind say, ‘I like to buy overvalued stocks?’ ”
“None,” of course, Rodriguez says. All value investors believe they are buying something on the cheap. The question is how do they define “cheap”? And what methods are they using to assess whether a stock is undervalued relative to what it’s worth now or what it will be worth in the future?
Among old-style value managers--the “purists”--the hunt for value still involves a search for deep discounts in terms of P/Es and other measures. By definition, that often means stocks that most investors currently don’t want.
For instance, let’s say a stock is trading at a P/E of 20 based on estimated 1999 operating earnings. Some value managers might say this could be an attractive stock, given that the S&P; 500’s average P/E is about 26--or if this company’s earnings are expected to grow faster than its industry peers.
However, many old-style value managers might still avoid such a stock. They might want a much lower P/E--say, 15 or less--to justify taking a chance on the stock, even if the underlying company’s earnings growth potential appears strong.
Such stubbornness--old-style managers call it discipline--has historically worked in their favor.
Numerous academic studies have found that stocks trading at very low prices relative to their earnings, assets or sales, have historically outperformed the market as a whole over long stretches of time.
The Hammond, Ind.-based newsletter Dow Theory Forecasts tracked the performance of stocks in the S&P; 500 that were trading at P/Es of less than 10 on Dec. 1, 1994. Had you bought those value stocks then and held them through Jan. 20, 1999, you would have earned an average cumulative return of 250%.
By contrast, had you invested in growth stocks with super-high P/Es on Dec. 1, 1994 (specifically, the S&P; 500 stocks trading at P/Es of higher than 40), you would have earned an average return of less than 50% through Jan. 20 of this year.
The moral, say old-style value managers, is that many high-priced growth stocks of 1994 were riding for a fall, or at least for sub-par future returns--the same argument they make about today’s market darlings.
Data like those keep many old-style value managers from going near many tech and telecom stocks, even though those companies now make up nearly a third of the S&P; 500’s market capitalization.
“I would love to own tech,” admits David Dreman, manager of the Kemper-Dreman High Return Equity fund and a legendary value investor. “And I would have been much better off to have parked my entire portfolio in Internet stocks, or the Nasdaq 100 index of tech stocks.”
But, he says, he can’t figure out a way to justify calling an Internet stock without any earnings, or Microsoft selling at its current P/E of about 64, an undervalued stock.
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For new-era value managers, however, the stock-picking rules of the old school are far too rigid--especially with regard to the tech companies that are leading the modern economy.
These money managers insist they still care significantly about valuations. But their methods of valuing stocks are more flexible, allowing them to own more of the growth leaders of the new economy.
John Gunn, chief investment officer of San Francisco-based Dodge & Cox, notes that his firm’s long-standing bent toward value investing has steered it to many old-line industrial cyclical companies, financial services firms and energy stocks.
But, Gunn argues, it would be foolhardy to ignore the realities of the changing economy, whose growth has been fueled largely by greater efficiencies engineered through technological innovation.
“It’s real,” he says. “This is a tangible happening. If we were to ignore this [segment of the economy], then we would be limiting ourselves in our search for investments to what would be a declining portion” of gross national product.
By traditional value measures such as P/Es, most tech stocks would be off limits to Gunn. But by relying on newer value measures--such as a company’s market capitalization relative to its sales--Gunn has been able to boost tech to about 12% of the $4.6-billion Dodge & Cox Stock fund.
Richard Meagley, manager of the $2.2-billion Safeco Equity fund, agrees with this approach.
He argues that it’s unfair to apply the same “valuation matrix” to a software company such as Microsoft--whose earnings are growing more than 20% a year--as you would to Exxon, whose earnings are growing about 6%. That’s because earnings go to the heart of a company’s intrinsic value, says Meagley, a value manager whose second-biggest holding was recently Microsoft.
But many old-style value managers see the rule-bending by new-era value managers as a cave-in to popular market sentiment.
Just to say a fund should own a particular stock sector because that sector is so large reminds some old-style value managers of what happened with energy stocks in the late-1970s and early-1980s. The stocks got so popular that they made up more than a quarter of the S&P; 500.
Yet in subsequent years, as oil prices dived, so did energy’s stake in the S&P;, notes FPA’s Rodriguez. “Just because something is a large component of an index doesn’t mean you have to own it,” he argues. After all, there’s no guarantee that it will stay that big.
But Robert Turner, manager of the $152-million Turner Growth Equity fund, argues that the rise of tech is different.
“The reason energy was up so high [two decades ago] was not because energy was leading to higher productivity,” he says. “It was simply because of an oil shortage.”
The productivity gains fueled by technological innovations have created “a big seismic shift in the market,” Turner argues.
While it will be possible for old-style value stocks to outperform growth in short spurts, Turner believes that in this new economy, the old definition of value investing simply cannot compete with growth. “It may never regain its footing,” he argues.
The old-style value managers say their peers will come to regret that kind of talk--though exactly when, they concede they can’t say.
“I’ve heard all these arguments before--that this is a new time or era,” says Dreman. “I don’t want to sound like a Tyrannosaurus rex, but a lot of that doesn’t wash.”
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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.
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How ‘Value’ Has Struggled
Historically, “value” stock funds and “growth” stock funds have taken turns leading the market. But, since 1997, growth stocks have been in the lead for nearly the entire period, and by an extreme margin. Average total returns for funds in the two sectors:
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Large-Cap Stocks
Third quarter:
Growth -3.6%
Value -9.6%
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Small-Cap Stocks
Third quarter:
Growth +1.1%
Value -7.1%
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Source: Morningstar Inc.
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Two Styles of Value Funds
Value stock investing has split into two camps. Old-style value funds are those whose managers tend to stick with traditional value stock criteria-favoring shares with low price-to-earnings (P/E) ratios, for example. “New era” value funds are those whose managers are willing to use more liberal criteria in judging what’s a “value.” Here’s a look at seven funds in each of the two camps. As the data show, the new-era value funds have generally trounced the old-style funds year to date and over the last five years.
‘Old-Style’ Value
Fund Name: FPA Capital
Objective category: MV
3rd-qtr. return: -9.6%
YTD return: 6.9%
5-yr. return*: 20.1%
Avg. P/E: 23
800 number: 982-4372
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Fund Name: T. Rowe Price Equity-Income
Objective category: LV
3rd-qtr. return: -8.5
YTD return: 3.0
5-yr. return*: 18.4
Avg. P/E: 28
800 number: 638-5660
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Fund Name: Tweedy Browne American Value
Objective category: MV
3rd-qtr. return: -7.3
YTD return: 2.5
5-yr. return*: 20.2
Avg. P/E: 20
800 number: 432-4789
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Fund Name: Vanguard Equity-Income
Objective category: LV
3rd-qtr. return: -8.4
YTD return: -0.6
5-yr. return*: 19.5
Avg. P/E: 28
800 number: 662-7447
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Fund Name: Hotchkis & Wiley Equity-Income
Objective category: LV
3rd-qtr. return: -11.5
YTD return: -2.5
5-yr. return*: 15.2
Avg. P/E: 22
800 number: 236-4479
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Fund Name: Kemper-Dreman High Return
Objective category: LV
3rd-qtr. return: -12.7
YTD return: -8.0
5-yr. return*: 19.5
Avg. P/E: 23
800 number: 621-1048
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Fund Name: Strong Schafer Value
Objective category: MV
3rd-qtr. return: -16.8
YTD return: -22.2
5-yr. return*: 8.4
Avg. P/E: 18
800 number: 368-1030
‘New Era’ Value
Fund Name: Strong Opportunity
Objective category: MV
3rd-qtr. return: -4.3%
YTD return: 13.7%
5-yr. return*: 18.8%
Avg. P/E: 30
800 number: 368-1030
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Fund Name: Dodge & Cox Stock
Objective category: LV
3rd-qtr. return: -8.1
YTD return: 12.1
5-yr. return*: 19.8
Avg. P/E: 31
800 number: 621-3979
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Fund Name: Vanguard Growth & Income
Objective category: LV
3rd-qtr. return: -5.0
YTD return: 8.0
5-yr. return*: 24.8
Avg. P/E: 32
800 number: 662-7447
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Fund Name: Legg Mason Value
Objective category: LV
3rd-qtr. return: -9.7
YTD return: 6.6
5-yr. return*: 33.1
Avg. P/E: 33
800 number: 577-8589
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Fund Name: Gabelli Westwood Equity
Objective category: LV
3rd-qtr. return: -7.5
YTD return: 4.1
5-yr. return*: 21.4
Avg. P/E: 29
800 number: 937-8966
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Fund Name: Alliance Growth & Income
Objective category: LV
3rd-qtr. return: -10.6
YTD return: 3.2
5-yr. return*: 22.1
Avg. P/E: 30
800 number: 227-4618
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Fund Name: Safeco Equity
Objective category: LV
3rd-qtr. return: -6.7
YTD return: 2.8
5-yr. return*: 20.0
Avg. P/E: 28
800 number: 426-6730
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Fund Name: Avg. large value fund
Objective category: LV
3rd-qtr. return: -9.6
YTD return: nil
5-yr. return*: 17.4
Avg. P/E: 27
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Fund name: Avg. mid-cap value fund
Objective category: LV
3rd-qtr. return: -9.6
YTD return: nil
5-yr. return*: 17.4
Avg. P/E: 27
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Fund Name: Avg. mid-cap value fund
Objective category: MV
3rd-qtr. return: -10.0
YTD return: 0.3
5-yr. return*: 14.0
Avg. P/E: 24
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Fund Name: Avg. small-cap value fund
Objective category: SV
3rd-qtr. return: -7.1
YTD return: -1.5
5-yr. return*: 12.3
Avg. P/E: 31
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Fund Name: Avg. domestic stock fund
3rd-qtr. return: -5.5
YTD return: 5.1
5-yr. return*: 17.9
Avg. P/E: 31
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*annualized returns
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Source: Morningstar Inc.
