5 Keys to Value Investing Profits

Value funds have long been viewed as conservative investments. So why are they down an average of 42% during the past 12 months, and what’s wrong with them?

No question, such numbers are scary, especially for large-cap value fund investors who have experienced that 42% drop. And the fact that some of the biggest names in value investing have taken such big beatings has to be especially disconcerting for investors who already have had their confidence badly shaken and their portfolios eviscerated.

Bill Miller’s once-vaunted Legg Mason Value Trust fund [LMVTX] has dropped 62%. Meanwhile, Marty Whitman’s Third Avenue Value Fund [TAVFX] is down 50%. Even the Dodge & Cox Stock Fund [DODGX] fund has tumbled 49% year to date.

For many investors who viewed value funds as comparatively “safe,” low-risk investments, this has to feel like a betrayal. And that’s understandable, given that history has repeatedly shown the value discipline to be one of the strongest, most stable investment strategies available for navigating a bear market.

What’s different this time?

Some managers – like Legg Mason’s Miller, as well as the Dodge & Cox team, for example – simply underestimated the depth and severity of the challenges facing their investments. Adding insult to injury, they concentrated their investments in a relatively small number of core holdings they thought they “knew.” During good times, this concentration strategy can dramatically boost returns when stellar companies that had been trading at deep discounts subsequently rebound. But now, when times are tough, as is readily apparent, stockpiling money in one or two holdings like Lehman Bros. Holdings Inc. [OTC: LEHMQ] or Freddie Mac (FRE) can be devastating.

Others, like Whitman – a gentleman who is often regarded as the “Dean of Value Investing” – simply don’t sell all that often, preferring to ride out market gyrations, which they view as a mere nuisance. So their performance is likely to suffer in line with the markets. But that’s not necessarily a bad thing. In fact, Whitman, who is notorious for looking beyond what the public markets do, doesn’t care that prices have fallen so low. He believes that undervalued companies will be taken over, liquidated or refinanced which, as he pointed out in an interview with Brian Zen last year, is “where you make your money.”

While such strategies put value players on the losing side of the investment ledger for now, it will be a different ballgame when the markets turn, as they eventually will.

In fact, when we emerge from the other side of the current financial crisis – which we will, and probably sooner than everybody realizes – the deep-value choices available today will be some of the highest-performing investments for decades to come.

And for all the right reasons: Many of the underlying companies are still expecting solid business growth, diversified revenue streams and a clear path to higher earnings.

That means that one of the smartest moves a savvy investor can make today is to stick with the value-investing discipline. The historical record suggests that the best choices continue to be those companies with low or no debt, a high proportion of international revenue, and a history of solid dividend growth that pays us cold, hard cash for the ownership risks we take.

That is why there is nothing “wrong” with making value investing a key component of your investment strategy. Especially now.

As for the notion that “value” investing is broken, we don’t buy into that. Studies show that investing styles come and go. For instance, indexing might hold sway for awhile, until it gives way to a total-return strategy. Then the momentum players hold the majority. And so on.

What’s important to understand, however, is that styles don’t work all the time; they work over time, which is why it is more important than ever to maintain a laser-like focus when the going gets tough. The following five guidelines can help you keep that focus.

Five Keys To Consider Right Now

• Be Patient: Investors have fled the markets in droves lately. According to TrimTabs Investment Research, mutual fund investors have pulled $175 billion out of stock funds so far this year, with $56 billion of that capital exodus taking place in October alone. This is the first year that equity flows have been negative since 2002, which reaffirms something we frequently point out: Investors tend to rush in at market tops and out at market bottoms. And that suggests that we may be approaching a bottom – even if it’s not immediately apparent.

• Rebalance: Tough markets can really skew your financial perspective. And your portfolio balance. “Rebalancing” can help you get back on track to higher returns, as we’ve mentioned in the past. Not only does rebalancing force you to take profits, but it also encourages you to put more money to work in areas that have been hit the hardest (and which are also poised for the biggest-potential rebounds, studies show).

• Look For Consistency: As redemption requests mount and conditions deteriorate, some value funds are shifting managerial styles in an attempt to make up lost ground. Not only does this suggest that these funds never had a strategy to start with, but it also suggests a lack of discipline, which is exactly what we don’t want right now. Studies show that value funds, in particular, tend to rebound more sharply than other investment choices because they’re often chock full of quality stocks trading at deep – but temporary — discounts.

• Make Sure Value Really Is Valuable: “Value” has many different meanings, so it’s important to make sure you understand what the term means when it comes to picking a suitable investment. For some managers, value means companies that are simply trading at steep discounts to other stocks. For others, it means a concentration on those stocks trading in predetermined ranges, perhaps as measured by such indicators as Price/Earnings (P/E) or Price/Book (P/B) ratios.  Different definitions can lead to vastly different types of stocks.

• When Buying On The Cheap, Understand That Near Term Outlook Often Stinks: During good times, value investing is often about buying companies that, at least in the near-term, have fallen on hard times. Now, however, pretty much everything is “cheap,” so the more important issue is identifying those companies with superior fundamentals and improving outlooks that may simply be caught in this bad-market maelstrom.

After all, Wall Street knows the price of everything. But very few people understand the value of anything.

Comments

[fjpenney:]

... or you could find/develop a decent market timer and use it like I did to get out of the markets back in June. Of course, this was a once in a lifetime decline (hopefully) but following my timer saved my skin.

2008 Nov 20 01:11 PM

[User 265729:]

*Be Patient: But really, you don't need to be too patient in this market. You'll lose everything you own in a matter of days or hours. Ask Prince Alwaleed Bin Talal -- when this sucker goes down I hear they sharpen their swards over there.

*Rebalance: (Translation) Be stupid and buy, buy, buy!

*Look For Consistency: Yes! The market is going down, the economy is going down, employment is going down, and home prices are going down, this sucker is going down.

*Make Sure Value Really Is Valuable: So Keith, how would I know that? You have the U.S. Government shilling-up the market every day. They are not telling anybody where the missing $2 Trillion went; every stupid business under the sun is turning into a bank or going to Congress to BEG for taxpayers' money in PRIVATE JETS. Now we have Citi begging off of the Saudi oil holes for more money that he promptly LOST in hours. NOW Citi want the U.S. Government to change the rules of EVERYTHING from uptick to short-selling laws.

*When Buying On The Cheap, Understand That Near Term Outlook Often Stinks: NOT ONE PERSON on this site has given me a scenario that things will improve in the near OR LONG TERM. Things improve - BAM! High oil prices will kill it off.

2008 Nov 20 02:13 PM

[The_Value_I...:]

Great write-up! Both comments above have nothing to do with value investing!

Patience really is a virtue in investing, often times when you have people such as investors to answer to you can't hold things as long as you want due to many investors and managers short-term focus. I bought Walter Industries(WLT) in June of 2007 for $32/sh. Despite managements near term shaky outlook I held it as shares plummeted to $23 as Pirate Capital sold out of it. By exercising patience I was able to enjoy the upward ride when Cerberus bought in along with many other investors. I sold it in May of 2008 around $80, before the peak but still more than double my money in less than a year b/c of patience.

Rebalancing is a tricky question. I prefer bottom up analysis so I don't tend to rebalance as often as others by letting good buys determine my mix rather than the broader markets views.

I also am a huge believe in consistency. Throughout the 90's everyone hated value guys. They weren't getting the #'s that growth and tech guys were, but in the long run, value wins out, and managers that tried to let the markets dictate their style lose out. Stick to what you know, don't back down.

And do make sure you know what cheap is.

2008 Nov 20 03:28 PM

[Tony Petroski:]

Nice article. Someone sensible amidst the "invest in a Smith and Wesson" crowd.

2008 Nov 20 05:32 PM

[Smarty_Pants:]

6) Wait for signs of a bull market

2008 Nov 20 09:04 PM