Asset allocation combined with value investing produces better results.

Many have breathed a sigh of relief as the market came off a great year in 2003, the first positive result in four years. There is some argument among different schools of thought as to whether a correction (or worse) is now due or how long such a strong rally can continue without ending in tears. Many investors took such huge losses in the late, unlamented downturn that even the fabulous gains of 2003 can't begin to make them whole.

Should investors give any credence at this juncture to the perennial debate about how to make the most or lose the least? There has long been an argument between those who believe in efficient markets and passive investing and those who believe in inefficient markets and value (active) investing. The passive investing school takes its lead from people like John Bogle, the venerable founder of Vanguard Group. The value investing school takes its lead from the equally venerable Warren Buffett. An evaluation of the results of investing using either of these two philosophies suggests that, in many cases, investors were better off with value investing than with passive investing over the last ten years.

For example, Warren Buffett's Berkshire Hathaway, which although not a mutual fund is itself a diversified holding, returned 19.20% over the last ten years, compared with 10.55% from a blend of indexes, and 11.61% from an S&P 500 index fund. Bill Ruane's Sequoia Fund returned an average of 16.74% over the same period. It is worth noting that these two are disciples of the legendary value investor Benjamin Graham. But no less than six mutual funds under the Franklin Templeton Investments umbrella also beat the passive index approach by wide margins, as do five funds at American Funds Group and at least two funds each at Fidelity Group, Dodge & Cox Funds, T. Rowe Price Funds and Tweedy, Browne Co. A host of other fund families, such as Lord Abbett Funds, Ariel Funds, Legg Mason Funds and Heartland Funds have at least one fund that has beaten the passive index approach over the past ten years. Most of the above funds also handily outpaced the indexes over the three-year, five-year and 15-year periods as well.

One claim made on behalf of passive investing is that the average investor stands no chance of outperforming the indexes over the long term. The average results for mutual funds support this. However, just as for the people in Garrison Keillor's "Lake Wobegon," there is no requirement that we be average. Some of us, perhaps thinking like one of Graham's "intelligent investors," could escape the averages by actively investing for value. History suggests that if we were to stay disciplined, we would end up as winners. The reasons for this are simple: Disciplined value investors lose less during downturns, make more over the long run and often pay less in the form of "risk" than passive investors. Value investors don't buy high and sell low, which is an easy thing to fall into with passive investing, and in some cases value investors don't sell much at all.

Ah, but can we really expect to put together a well-balanced, fully diversified portfolio using value investing as a guide? Or must we "regress to the mean" as the passive investment crowd would have us believe? Warren Buffett has argued that standard portfolio diversification is for many a protection from ignorance, and therefore fits "defensive" investors best. Buffett and Graham before him have also argued persuasively that focus investing with built-in "margins of safety" is best for more "enterprising" investors. For many advisors who lack the talent of a Buffett or a Ruane, it may make sense to compromise by using well-managed value funds in portfolios we recommend to clients. A case can be made that even when asset allocation is used in a relatively conventional manner, but with the value discipline predominant, the results are excellent.

I constructed a series of portfolios using this approach. I modeled them for the most recent ten-year period to demonstrate the advantages of using value-style investment decisions to enhance asset allocation and improve portfolio performance. There are many ways to do this, but the five value-driven portfolios modeled yielded very good historical results. This is not just "20/20 hindsight" either. The portfolios modeled were picked using value parameters as the main guidelines, rather than just performance. Almost all of the mutual funds chosen for the portfolios have 15-year histories. This is because it is critical to show that these funds had sufficient track records to permit them to have been chosen by a value investor ten years ago as part of a model portfolio. All of this suggests that it is possible to use common sense notions about value investing in constructing a portfolio with lower than average risk and higher than average performance.

Theory And Assumptions Used In Value Investing

All investors seek growth, but value investors use built-in margins of safety in stock valuations, rather than low volatility in prices, as guides to risk. This is because value investors, following the lead of Benjamin Graham, don't believe in good stocks, only in good companies. The margin-of-safety concept that Graham prefers is part of the value received for the price paid at the time a stock is purchased. The value investor thus seeks growth but does not focus on prices alone or pay much attention to market trends. Essentially, value investors tend to look at buying stocks as really buying the companies underlying the stocks. By acting like owners, they tend to stay in their holdings longer, and that raises performance and improves tax efficiency. How do value investors navigate if they don't look at market trends? They do bottom-up fundamental stock analysis and look for irrational prices. To paraphrase Warren Buffett, the value investor is a realist who buys from pessimists and sells to optimists.

Value investors like Charles Brandes of Brandes Investment Partners hold that the "Strong" and "Semi-Strong" versions of Efficient Market Theory are valid at times, but invalid at other times, such as in the recent buildup and deflation of the market "bubble." These episodes of market inefficiency or illogic provide opportunities for value investment managers to back up the truck and load up on discounted stocks. Not that you need a bear market to be a value investor, but it sure makes it easier. In fact, some value stocks were out of favor before the bubble collapsed, but shot upwards once the collapse occurred, securing large gains for some value investors in the midst of general losses. Combining the purchase of discounted stocks with low turnover and relatively focused (concentrated) portfolios permits the value approach to be applied very successfully by some mutual fund managers. Low portfolio turnover (less than 25%) characterizes disciplined value investing. Focused or concentrated portfolios, with the top ten holdings containing say, more than a 40% weighting, are characteristic of the more unorthodox managers like Warren Buffett or Bill Ruane. However, although unorthodox with respect to theory, focus investing also yields spectacular results for those with the talent to do it properly. More conventional diversification using portfolio optimization with less concentration lowers the overall performance. However, this approach, when combined with a value-driven philosophy, yields remarkably low volatilities and high Sharpe ratios for entire portfolios, even though these might not be specific goals for any individual fund managers.

Value investors in general tend not to worry as much about statistically derived indicators of risk, as they do about getting stocks with low P/E ratios, low P/B ratios, low debt ratios, high earnings yields relative to bonds and consistent dividend and earnings histories. Indicators such as standard deviation or beta are considered by some to be at least partially misleading because they measure volatility rather than risk of loss. This makes sense in context, that is if you remember that value managers are acting like business owners, not stock traders. As analyst and author Robert Hagstrom has pointed out, you wouldn't sell a business just because its market price is volatile, especially if you have no prior intention of selling, based on earnings fundamentals. Indeed, many value managers produce laudable results such as consistently small bear market dips, and yet have only average standard deviations. We all know that investor psychology and discipline are critical to preventing losses during general market declines, so these smaller bear market dips are a big advantage. Nevertheless, when a combination of value managers is used, it is possible to construct a portfolio having very low characteristic risk parameters. While achieving low risk statistics is not a goal of value investing, it is still a good thing for most investors.

Hard-to-measure variables like the rationality of management can also be critical to value managers. Not many value managers got caught with Worldcom or Cisco or Enron or Tyco stock, because in each of these cases there was public information available that called into question not just the accounting, but also the rationality of management. The valuations and sharp declines of these stocks and many others have been discussed in detail by Jason Zweig, whose commentary is part of the latest revised edition of Graham's classic The Intelligent Investor.

The reader should also consider the gap between investor behavior and market logic. For example, Brandes points out that studies by Dalbar Inc. have shown that although the stock market averaged 16.3% annual returns from 1984 through 2000, the average fund investor made an average of only 5.3% annually on equities. To make matters much worse, average fund retention was only 2.6 years, in spite of most investors' long-term investment horizons. My personal experience is that many investors seek great managers but then second-guess them regularly. We've all heard the one about how most of the legendary Peter Lynch's fund investors made no money because they didn't keep their shares. I believe that value investing holds the key to changing this kind of behavior. Value investing, when properly explained and adhered to, takes the investor's eye off prices and refocuses them on staying in for the long haul, like a business owner. The results are worth having, and it is our job to convince our clients to change their thinking.

Portfolio Construction Basics

Six model portfolios were constructed to evaluate risk and return relationships for various value-driven parameters. Portfolios have been modeled using March 31, 2004, data on Morningstar Principia Pro software. Principia Pro portfolios are automatically rebalanced on a monthly basis. The portfolios are all set to the same general allocation, 70/30 stock/bond, using a model allocation somewhat modified from PIE Technologies MoneyGuide software. Mutual funds and stocks were chosen for each model portfolio using various guidelines discussed below. The initial list consisted of 100 funds with at least ten-year records, and good relative performance in the three-year period of the recent bear market. (The funds chosen for this study are not recommended for investors; rather, they are used merely for evaluation purposes.)

The baseline portfolio for comparison purposes uses a 70/30 mixture of index funds, which is labeled here as the Baseline Index Aggregate. Equity index funds for each market capitalization class included in this portfolio are all "blended" with respect to growth vs. value styles. A small proportion of a real estate investment trust (REIT) fund is included in some of the models to partially account for the role played by alternative value investments. Eight passive index funds are included in the Baseline Index Aggregate, six of them from Vanguard Group. The model allocation is: large-cap blend (LCB) using Vanguard 500 Index, 32%; mid-cap blend (MCB) using Vanguard Extended Market, 10%; small-cap blend (SCB) using Vanguard Small-Cap Index, 8%; international stocks (ITL) using Schwab International Index, 10%; real estate equities (REE) using Vanguard REIT Index, 10%; short-term bonds (STB) using Vanguard Short-Term Treasury, 5%; intermediate-term bonds (ITB) using Fidelity Spartan Government Income, 10%; and long-term bonds (LTB) using Vanguard Long-Term Bond Index, 15%. This model approximates the results gained in the last ten years from passive index investing, hence the term baseline.

A High Dividend Stock model was prepared by screening 34 stocks paying dividends greater than 3.50% from a list of high-dividend stocks, combining that with three bond funds in a 70/30 allocation and ignoring the mid-cap, small-cap and international asset classes. Real estate is partially covered however by the inclusion of three REITs in the list of 34 stocks used. Thus the equity portion of this model uses individual large-cap stocks and no mutual funds. Model allocation is as follows: LCV-34 stocks-70%, STB-PIMCO Low Duration A-5%, ITB-PIMCO Total Return A-10%, and LTB-PIMCO Long-Term U.S. Government A-15%. This model approximates a low activity level of value investment that is very tax efficient and involves little tactical management once the initial stocks are chosen.

The Value Funds Only model was constructed using nine funds that passed muster on at least five out of eight value measures available or easily derived from Morningstar Advanced Analytics software. These value measures are: Morningstar's best fit classification, dividend yield greater than 1.50% (S& P 500 avg.), P/E less than 25, P/B less than 3.50, P/CF less than 14.00, earnings yield greater than 4.25% (ten-year Treasury yield), turnover ratio less than 25%, and assets in top ten holdings greater than 40%. All funds also were required to have good relative numbers for the "worst three-year return" calculated by Morningstar. The model allocation is as follows: LCV-American Funds Washington Mutual A-32%, MCV-Ariel Appreciation-10%; SCV-Fidelity Low-Priced Stock-8%, ITL-Tweedy, Browne Global Value and American Funds Capital World-10%, REE-Cohen & Steers Realty Shares-10%, STB-PIMCO Low Duration A-5%, ITB-PIMCO Total Return A-10%, and LTB-PIMCO Long-Term U.S. Government A-15%. This model attempts to show a variation on asset allocation using value funds only, but without strict rules about which of the eight value parameters should be dominant.

A Best Diversification model was constructed using the lowest (R2 less than 0.70) three-year R-squared correlation statistics for funds in each asset class other than large cap. In addition, except for large-cap growth, funds having at least four of the eight value measures mentioned above were used to fill out the rest of the asset allocation. All of the funds were also required to have good relative numbers for the Morningstar "worst three-year return." Nine funds were used in a model allocation as follows: LCV-American Funds Washington Mutual A-16%, LCG-American Funds Growth Fund-16%, MCV-Ariel Appreciation-10%, SCV-Heartland Value-8%, ITL-Tweedy, Browne Global Value-10%, REE-Cohen & Steers Realty Shares-10%; STB-PIMCO Low Duration A-5%, ITB-PIMCO Total Return A-10%; and LTB-PIMCO Long-Term U.S. Government A-15%. This model attempts to balance diversification with value-driven investing, producing a low correlation and thus lower risk allocation.

The Smaller Market Caps model was constructed using only funds with mid-cap or small-cap average market capitalizations (less than $10 Billion). In addition, each fund was required to have at least four of the eight value parameters mentioned above, and the lowest average turnover possible. Again, all of the funds were required to have good numbers for Morningstar's "worst three-year return" relative to the index. Ten funds were used in a model allocation as follows: MCV-Franklin Rising Dividends A, Lord Abbett Mid-Cap Value A and Ariel Appreciation-30%, SCV-Heartland Value, Fidelity Low-Priced Stock, T. Rowe Price Small-Cap Value and Franklin Balance Sheet-40%, STB-PIMCO Low Duration A-5%; ITB-PIMCO Total Return A-10%, and LTB-PIMCO Long-Term U.S. Government A-15%. There is no allocation for real estate in this model. The model attempts to show the results of trying to harvest both the "value premium" and the "small-cap premium" noticed in studies of returns by Ibbotson Associates and others.

The last model presented here, the Focus Mix model, was constructed using as a screen a combination of low average turnover (less than 25%) and high, even unorthodox (greater than 40%) average percentages of "top ten" assets held in funds. All funds also were required to have at least five of the eight value measures, and to have good relative performance for Morningstar's "worst three-year return." The weighted average turnover for equities in this portfolio is only 14.8%. Nine funds were used in this model, as follows: LCV-Sequoia Fund and Legg Mason Value Prime-42%, MCV-Franklin Rising Dividends A-10%, SCV-Franklin Balance Sheet- 8%, ITL-Tweedy, Browne Global Value and American Funds Capital World-10%, STB-PIMCO Low Duration A-5%, ITB -PIMCO Total Return A-10%, and LTB-PIMCO Long-Term U.S. Government A-15%. There is no allocation in this model for real estate. The model shows the impact of combining asset allocation with a somewhat unorthodox value investing style that involves true long-term "buy & hold" discipline.

Results And Interpretation

A summary of the results appears in Table 1. From the table you can see the wide range of results produced for a ten-year period, compared with results for the Baseline Index Aggregate and for an S & P 500 index fund alone. The Baseline Index Aggregate has an average ten-year annualized return of 10.55%, compared with 11.61% for the S & P 500 index fund alone. The bear market dip produced a "worst three-year return" of -5.68% for this portfolio, compared with -14.4% for the S & P 500 index fund alone. The ten-year standard deviation and beta are quite low, alpha is modestly positive, the Sharpe Ratio is moderately positive, and the R-squared correlation is high.

The High Dividend Stock model has an average ten-year annualized return of 12.11%, beating the Baseline Index Aggregate by 1.56% annually, and beating the S & P 500 index fund alone by 0.50% annually. The "worst three-year return" for this portfolio is +4.76%, considerably better than that for the Baseline Index Aggregate. The ten-year standard deviation is low, beta is very low, alpha is moderately positive, the Sharpe Ratio is moderately high, and the R-squared correlation is very low.

The Value Funds Only model has an average ten-year annualized return of 12.47%, beating the Baseline Index Aggregate by 1.92% annually, and beating the S & P 500 index fund alone by 0.86% annually. The "worst three-year return" during the bear market dip was +4.14%. The ten-year standard deviation and beta are very low, alpha is moderately positive, the Sharpe Ratio is quite high, and the R-squared correlation is moderate.

The Best Diversification model has an average ten-year annualized return of 12.60%, beating the Baseline Index Aggregate by 2.05% annually, and beating the S & P 500 index fund alone by 0.99% annually. The "worst three-year return" was +1.86%. The ten-year standard deviation and beta are quite low, alpha is again moderately positive, the Sharpe Ratio is again quite high, and the R-squared correlation is moderately high.

The Smaller Market Caps model has an average ten-year annualized return of 13.24%, beating the Baseline Index Aggregate by 2.69%, and beating the S & P 500 index fund by 1.63%. The "worst three-year return" was +5.70% during the bear market dip, a whopping 11.38% better than the Baseline Index Aggregate, and 20.10% better than the S & P 500 index fund. The ten-year standard deviation and beta are quite low, alpha is very positive, the Sharpe Ratio is quite high, and the R-squared correlation is quite low.

The Focus Mix model has an average ten-year annualized return of 13.84%, beating the Baseline Index Aggregate by an outstanding 3.29% annually, and beating the S & P 500 index fund by a very impressive 2.23% annually. The "worst three-year return" produced during the bear market dip was +2.66%. The ten-year standard deviation and beta are moderate, alpha is very positive, the Sharpe Ratio is very high, and the R-squared correlation is high.

These value-oriented models demonstrate that investors could have chosen several different ways to proceed 10 years ago and still have beaten the passive index approach by wide margins. In most cases this would have been achieved with low relative long-term risk and very low bear-market risk. Value investors therefore could have lost less during downturns, made more overall, and paid less in the form of portfolio volatility during the roller-coaster ride stocks took in the last ten years. Although a few somewhat unorthodox value investors think standard portfolio and/or individual security statistics are relatively useless at the fund management level, these statistics in fact support a more diversified (i.e., less concentrated) value-oriented approach quite well. This is not a huge surprise, since Ibbotson Associates data have shown value stocks outperforming growth stocks by very wide margins over the last 75 years. But most asset allocation optimization models (and investors) continue to insist on equal weighting for growth stocks in each market cap category. The results presented here suggest we could justify seeking good value managers and ignoring or at least diminishing the so-called advantages of high turnover, price-driven growth stock investing in constructing portfolios. In a stock picker's market, which some believe we will be in for some time to come, this may serve our clients well.

Changing The Way You Advise Clients

It makes sense to divide clients into "defensive" investors who might do better with the more conventional or conservative portfolio approaches, and "enterprising" investors who could do well with a more disciplined value investing approach. The most sophisticated and disciplined investors in this latter group might even do well with a focused portfolio. The way to evaluate to which group people belong is to first know the client well, and second, use a very detailed risk profile. Good examples are the one produced by well-known advisor and author Deena Katz (website: www.evensky.com), and the one produced by the folks at ProQuest Ltd. (Web site: www.risk-profiling.com). Once you've figured out approximately what type of investor your client is, it makes sense to show them portfolios like these, or ones that are similar which you construct yourself. The most "defensive" type of investors could have their assets put in portfolios similar to the Baseline Index Aggregate or the High Dividend models. More disciplined "defensive" investors could be put in a portfolio similar to the Best Diversification model. Typical "enterprising" investors could be put in allocations similar to the Value Funds Only or the Smaller Market Caps models. The most sophisticated and disciplined investors could opt for a concentrated allocation similar to the Focus Mix model. It will be important for advisors to help all of their investors stay focused on things like value philosophy, turnover rates, P/E, P/B, earnings growth, earnings yield, etc., rather than just stock prices, momentum or market predictions. In so doing you will have fulfilled your primary duty to your clients, which is to "first, do no harm," or as some value investors have paraphrased it, "first, don't lose money."

Kevin M. Wilson, ChFC, is a financial consultant with M & I Financial Advisors in Minneapolis.