Will value stock funds
continued to outpace growth?
Value managers like shopping analogies when
explaining the market to people. John Buckingham, CEO and chief
investment officer of Al Frank Asset Management in Laguna Beach,
Calif., uses a peanut butter analogy when talking about the mentality
of investors chasing growth.
"Let's say you want to buy a jar of peanut butter," he says. "Last week you bought it at $2, and this week it's at $20 a jar. You wouldn't be inclined to buy it at $20. But in the stock market, you are ... because investors don't take the time to do fundamental analysis." The point? It's a value play.
Another case in point: The 1990s, when people were buying stocks that were already expensive just because they were sexy ... and had grown ten times already ... and maybe the thought was that they could grow by that much again.
The value managers got the last laugh (and the higher returns for the next few years) when the high-fliers fell to earth.
But how long can payback last? That's the question growth managers have been asking recently, as value managers continue to best them on the performance charts. It's been about seven years since the tech boom ended in an implosion and value stocks, once beaten up and left for dead in the dot-com era staged their dramatic comeback at the beginning of the decade, starting a run of outperformance that continues to this day.
According to Morningstar Inc. mutual fund analyst Todd Trubey, value funds have beaten growth for most of the years since 2000. The typical large-cap value fund cumulatively gained 59% from the beginning of 2000 through the end of 2006, he says, while the typical large-cap growth fund lost 18%. For value managers, it's sweet revenge.
"From 1995 to 2000, you had people justifying the S&P having a 30% weight in technology and the average P/E ratio weighing in at 30 times," says James McGlynn, a managing director in equities at Summit Investment Partners in Cincinnati and a portfolio manager of the Summit Everest Fund. "It made no sense to have the heaviest weighting in growth, which is the most expensive sector."
For the first few years of its run-up, the value story was about these beaten down stocks recovering their profitability. But as the value reign continues, new forces have come into play, including the strong economic recovery, and the more risk-averse investors' shift toward stable returns and dividend yields-things that favor the value universe.
"Value was starting from a very low point," says Colin Glinsman, the chief investment officer at Oppenheimer Capital and manager of the Allianz OCC Value Fund. "Growth had outperformed in the 1990s through the bubble, and that set us up for a few years of growth because value had been so out of favor. The second thing is that just out of the period when the bubble burst, we started to have this economic recovery. It turns out to have been a healthy recovery, so healthy that the value market has almost become overheated."
But the case of one style long outstripping another has gone on longer than most people expected, and it has them wondering when the pendulum will swing back and growth stocks will once again seize the day. Could this be the time? Famous value managers like Jeremy Grantham now believe certain traditional growth stocks like Microsoft and Johnson & Johnson, which have gone sideways for half a decade, offer more value than mainstream value stocks.
Others think so as well. Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co., a broker-dealer in Florham Park, N.J, points to problematic fundamentals in the traditional value world, which is thick with financial and energy names.
"On the value side, energies and financials will not be the growth engines in 2007 or 2008, and I'm particularly concerned about financials, because whether you're talking about investment banks [and money center banks], full service or multinational banks, they've having to contend with a variety of issues-interest margin compression, the drying up of the consumer loan volume, the interest yield curve and the slowing of underlying growth rates, so earnings in these companies will not be what they have been, and that fosters a falling stock price," Battipaglia declares. On the energy side, he says, looking out over the next several years, the price of energy will not move materially higher, which means the momentum for earnings slows.
Not so with growth stocks, which he says have less to do with the interest rate environment and the housing sector and more to do with staple spending. Thus, he believes that growth stocks will gain simply because they are not as dependent on how the underlying economy behaves.
Still, other industry watchers believe that value could continue to outperform, especially if the economy begins to slow, since investors would likely seek less volatility and a flight to quality. "That's often a reason for investors to pull in their horns a bit and do a little bit more value investing," says Andrew Clark, head of research at Lipper in Denver. "Also, when you just step back and look at the market from a broad standpoint, the S&P last year was characterized by a decline in revenues per share for the entire year. That's often a sign that a slowdown is on the horizon, and these sorts of feelings are part of the impetus behind value."
Another strong wind behind value is all the LBO and merger mania, as dealmakers circle beneath the chop looking for companies with a lot of cash in their blood. "A lot of the traditional value stocks that are just cheap on earnings have had their value inflated by potential leveraged buyout activity," says Ed Maran of Thornburg Investment Management in Santa Fe, N.M. "So companies suitable for private equity investment are not trading as cheaply as they historically had, and the inverse is that growth stocks are trading cheaper relative to the market. Stocks trading at low multiples of cash flow can be more easily financed and they can substitute that for equity, which tends to chase cash."
Financials and energy have contributed so much to the continuing value surge that active managers have had a hard time keeping up with the large-cap value indexes. According to Morningstar, the Russell 1000 Value Index was up 22.25% in 2006, and only 6.01% of active large-cap value managers beat it. Some managers say that this is because of the outperformance of financials and energy during the year and the fact that most managers didn't want to weight as heavily as the index did. Financials now make up 36% of the index and energy represents about 14%, according to Russell Investment Group, in Tacoma, Wash. In addition, many mid-cap value stock included in Russell 1000 Value Index beat their larger counterparts.
"Most active managers won't take that big a bet in financials or in any one sector, and the financials did quite well in 2006, particularly helped within the index by the REITs and capital market firms," says Sheldon J. Lieberman, portfolio manager of Hotchkis and Wiley Capital Management's Large Cap Value and Core Value funds in a Jan. 12 conference call with investors.
Strange enough that it's doing so well when, after all, there seem to be as many definitions of value as there are value portfolio managers. Some like book to market value, and some like a lot of cash on the balance sheet-a cushion that lets them sleep easier at night. Some like a stock that's been unfairly trounced only within its own peer group. Like the Littlest Giant in the Ren and Stimpy cartoons. Maybe you could complain that their multiples are "merely large."
Making it more complicated is that growth stocks have been so beaten up that they are starting to look more like value stocks themselves. Even technology stocks, long considered the creamy center of growth investing, have begun popping up in value funds.
"From a fundamental standpoint, to use an old saw, value has become the new growth," says Lipper's Clark, "because the fundamentals of growth stocks and fundamentals of value stocks are almost on top of each other. At the broad measures like P/E and price to book and operating cash flow, there's not that much difference going on."
"Multiples have compressed toward the middle from both ends," says Glinsman. "This has hurt the companies that were expensive and helped the companies that had low multiples."
"We've always had a view of value that was more comprehensive, saying that value is more than just valuation," says Maran, who is the co-portfolio manager of the Thornburg Value Fund. "If you can get a high-quality growth company at a valuation multiple not much different than the overall market, then that can be a good value, too."
Former high-flier Microsoft, once seen as the poster child of the 1990s go-go technology growth, is getting lots of attention, even though its new Vista version of Windows is getting a cool reception. Microsoft's total return from December 31, 1995, to March 31, 2000, was 869%, according to FactSet Research Systems Inc. It has now mellowed into a perfect value play and appears in many value portfolios.
"Microsoft had 11% [revenue growth] in 2006," says Trubey. "It was 8% in 2005, and 14% in 2004. To a growth investor who is used to this company doing 25% to 30%, it's dismal. To somebody who doesn't care if the growth is slow, that's pretty good growth."
Buckingham is one manager who sees many technology stocks as value plays for the Al Frank Fund. "Tech stocks are a significant component of our recommended list today because they have fallen behind," says Buckingham, the fund's lead manager. "That's a differentiation from us and most of our peers."
The Al Frank fund does not adhere to an index. It looks for value stocks with a three- to five-year time horizon, and while they favor companies with inexpensive valuation metrics, they won't shy away from blue chip companies that are relatively inexpensive such as Microsoft, Intel Corp., Texas Instruments and Applied Materials-stocks in the tech space with room to grow.
"In tech we're focusing a lot on balance-sheet strength," he says. "Microsoft has a great balance sheet. We might buy something with a higher earnings multiple as long as they have attractive balance sheets. We think the earnings will be there in the long term so that the multiple will come down. ... It's cash-rich, debt-poor companies we favor."
Dimensional Fund Advisors, on the other hand, uses a passive, quantitative deep-value approach, sorting by book-to-market ratios to help identify growth stocks and lower-priced value stocks. "We're not saying that they're underpriced or overpriced. We're saying that they're fairly priced," says Dimensional spokesman Weston Wellington. "We sort based on book-to-market ratio. You can use others, but using book value is a more stable measure. If you use earnings, they're much more volatile. Earnings gyrate a lot from year to year. Earnings is a noisy measure."
Maran says the Thornburg fund divides his picks into "basic value," "consistent earners" and "emerging franchises," and he has also included tech stocks like Microsoft, Dell and Oracle. "Another place where there's real good value is in companies where cash flows are a lot different than underlying earnings," says Maran.
He cites such examples as cable TV concern Comcast Corp. and wireless services provider American Tower Corp., both of which are in the top 25 holdings. "These are companies which have spent their money upfront to put huge infrastructure in place, and it's unlikely any new competitors are going to come in and compete with them aggressively because of the barrier to entry that that infrastructure spend represents," Maran says. "The appreciation on those old expenditures depresses earnings, but the cash flows are a lot larger, so the free cash flows are a lot greater than earnings. They look expensive on a P/E basis, but if you look at price to free cash flow, they look dramatically more attractive."
Curtis Jensen, co-chief investment officer at Third Avenue Management LLC in New York and portfolio manager of the Third Avenue Small-Cap Value Fund, says his fund is trying to buy companies at a discount to what they think those stocks would be worth if they went private or became a business takeover candidate, but which, for one reason or another, are not appreciated in the public markets.
"We're looking for areas where the business values are growing, but we just don't want to pay for it," he says. "We define value as a phrase meaning safe and cheap. ... In other words, a strong balance sheet with high quality assets and a lack of encumbrances or liabilities on the balance sheet or in the real world."
Glinsman says that his fund is looking not for companies that are cheap but are "misvalued" next to companies like them-undervalued on their own terms, whether it be in the low-multiple or high-multiple camp. "If we find a low-end growth company trading at 15 times earnings and we think it should trade at 19 times, we'll buy that more than a company trading at 12 that should be 13," he says. "We're looking for 'misvaluations.' That's how we define value."
He says that under this model one controversial pick for value managers might be Wal-Mart Inc. Controversial "on the fundamentals," he says, "because some would regard it as a broken growth stock that is correctly valued, whereas others would regard it as a healthy growth stock that has simply slowed down some and deserves a higher valuation."
McGlynn says his fund tries to remain sector-neutral, but then will overweight in certain subsectors, focusing on natural gas rather than oil, or on the media area of consumer spending rather than retail. "Last year we stepped in and bought some Cisco Technology," he says. "I said in 2000 I could never imagine owning a name like Cisco, but a couple of years later it's cheap enough."
March Madness Sale-Starting In February
The current market turmoil is something that, as expected, has empowered some value managers more than discouraged them. A market downturn like the one on February 27, when the Dow Jones Industrial Average plunged more than 400 points, is often a time when it rains deals because good companies are suddenly unfairly undervalued.
"I would view it as market opportunity, not turmoil," says Buckingham. "If you're a long-term net buyer of stocks, you don't mind when stocks go on sale. It's been terrific for us. We've had names we haven't been able to put on the buy list forever. So what do we think of the market turmoil? Thank you!"
Among those companies that he could buy because of the roiling markets are Best Buy, Caterpillar and Amgen. But he emphasizes that value managers believe in holding stocks, not necessarily moving in and out of markets quickly.
"Like Warren Buffett says, if the market closes for a couple of years, it wouldn't matter much. The stock market exists in Buffett's view to see if somebody's willing to do something foolish-are they willing to offer you enough inexpensively or buy something for too much," Buckingham continues. "If there's value you buy it, and if there's not, you keep your money in your pocket. Your success has not been in buying great companies but in holding great companies for their long-term potential. or me, trading is investors' worst enemy."