After several strong years, finding cheap stocks is tougher.
If the last five years have been trying times for
many investors, they have produced good times for value investors. That
hardly means that the first five years of the new millennium
represented a golden age for value.
Instead, value investors' success has been mostly a
matter of relative performance. Some leading value managers say
privately they wish they were big enough as people not to derive a
certain measure of satisfaction from the travails of their counterparts
in the growth arena. And after the last five years of the previous
millennium, when markets made value managers look a lot less swift than
daytraders and chimpanzees (there was little difference), those who
made it through the 1990s feel like tsunami survivors.
Since the bubble burst in March 2000 value, has
outperformed growth by 15% a year, according to several measures. But
the degree of outperformance is more attributable to the sorry behavior
of many growth stocks than any sizzling spike up in value. Ironically,
the continuing punishment that many growth stocks have received has
transformed some of the most famous, high-flying companies, like
Pfizer, into value stocks, confirming all the old verities that value
investors love to cite.
A return to reality, a reversion to the mean, a
restoration of reason, call it what you want. After five years of what
some would call a bear market and others would term a sideways market,
most serious investors are reaching the conclusion that most financial
assets are fully and fairly priced.
Take Robert Rodriguez, manager of FPA Capital Fund.
In a narrative on his Web site, dubbed Slim Pickings, in late January,
he detailed the rather depressing process he and his staff went through
reviewing all 1,382 companies in the Russell Value index. Among
possible candidates that met their criteria, they found 95 companies,
seven of which they already owned. Upon further review, half of the
remaining 88 were quickly eliminated.
After shooting down another 35 concerns, they
wrestled over a list of five companies. Rodriguez's associates came up
with convincing reasons to avoid four of the five survivors. He then
had his colleague, Steven Romick, review the list to see if they had
missed something. Romick identified four companies but conceded that he
wasn't enthusiastic about any of them.
So Rodriguez went back and used another of his
traditional screens to make sure he wasn't overlooking any companies.
This set of criteria produced 70 candidates, or 25% of what it did one
year ago, and the fewest number of companies since early 1998.
Today, Rodriguez worries that investors are
continually raising their forecasts to rationalize current prices. They
may be correct, but he can't find "a sufficient margin of safety."
Other value investors don't think the pickings are
quite that slim. Cliff Asness, who manages institutional pension money
and a hedge fund at AQR Capital in New York, says, "As we measure it,
the spread between value and growth is not as narrow as others find.
So, we think value is still OK."
As stock price levels have climbed over the last
decade, some value investors have shifted away from the classic deep
value investing method of trying to find underpriced assets with a
liquidation value that exceeds the stock price. More and more, they are
looking for companies that can turn their businesses around and
surprise investors on the upside.
"The lines [between value and growth] have always
been blurry," says Jim Averill, a portfolio manager at Wellington
Management and manager of the Hartford Value Opportunities Fund.
"Aluminum was a growth sector in the 1950s, color TVs were in the
1960s, energy was in the 1970s, and tech always comes and goes."
But unlike growth stock followers, value investors
remain hyperconscious of the price they pay, and many will look to sell
as soon as a stock reaches a fair price. "We've owned homebuilders
forever-until recently," Averill says. "We're no longer in them. Our
feeling is when [their price] gets over two times book value, they are
overpriced. There is overenthusiasm in housing right now."
Another major difference between growth and value
investors is that the former sees problems at a company as reasons to
head for the exits while the latter views them as opportunities. New
product pipeline problems and political issues have caused
pharmaceutical stocks to fall out of favor in many growth portfolios,
but Averill is finding compelling values in Pfizer and Wyeth.
"We are enthusiastic about health care," he says.
"Right now we own less HMOs and more pharmaceuticals, and that's purely
price-driven."
Despite the run-up in prices, Averill still has 8%
of his fund's portfolio in energy stocks. Key holdings include Total, a
large French oil company which he thinks has the "best prospects for
growth," along with Marathon Oil, a big refiner, and Devon Energy.
Fully 28% of Averill's portfolio is in financial
services, although he's looking at sectors and companies that are
relatively immune to rising interest rates. In recent decades,
financial services companies' earnings have become less sensitive
to rising interest rates than their stocks have. Plus, credit card
companies have the ability to raise rates, Averill notes. And one of
his key holdings, Citigroup, gets between 30% and 40% of its earnings
overseas, where rates may not rise.
Looking beyond Wall Street's myopic time horizon is
the driving methodology behind the Oppenheimer Value Fund and the
entire value group at the fund complex. Chris Levy, head of the group,
says that 86% of the performance differential among value stocks is
explained by the earnings of the companies going forward.
What he and his team focus on is the three-year
earnings outlook for each company they examine. Why? "If you look at
how the typical large-cap stock is followed on Wall Street, there are,
on average, 23 analysts with one-year estimates, 20 with estimates for
two years and six with three-year projections," Levy says. "So that's
where the analytical sweet spot is. Three-year earnings power doesn't
get much attention."
That said, it often takes a turnaround or catalytic
event to achieve the kind of result Levy seeks. A case in point is
former holding Aetna. When Oppenheimer bought the HMO, it was losing
members and selling at a very low price-to-earnings multiple to its
peers.
"They had created a negative customer selection bias
where they were attracting a lot of sick people, to put it bluntly," he
says. "We felt new management would develop a new pricing strategy that
would address the negative selection problem. We also thought it could
attract a better, healthier customer without hurting their pricing so
they could raise their margins. They did."
Robert Olstein, manager of the Olstein Financial
Alert Fund, takes a strong value orientation but prefers to
differentiate between value and momentum, not value and growth. A
forensic accountant, Olstein analyzes companies' cash flow in
painstaking detail and prefers not to speak to management, considering
it to be a waste of time.
"We care about what management is doing, not what
they are saying," he explains. "Spending one night with a financial
statement analyzing the numbers is worth more than spending two nights
dining out with management. Financial information has improved
dramatically, but most people don't pay attention to it."
Since 1995, Olstein's fund has generated a return of
16.7% annually. Spotting turnarounds is one of his specialties. His
biggest winners have included McDonalds, Tyco, Disney, Merrill Lynch
and J.C. Penney, all of which fell out of favor in the last decade but
staged strong comebacks.
Currently, he holds the besieged investment bank,
Morgan Stanley, which he purchased in the mid-$40-a-share range. "We
think it's worth $60 to $65 a share," he says.
Realizing that value could be tricky, he
acknowledges. Morgan Stanley's embattled CEO, Philip Purcell, has a
board that appears to be packed with cronies, and ousting him, as
dissident shareholders are seeking, requires a vote of 75% of the
board. "He's a very good politician," Olstein concedes.
Another beaten-up area he likes is the newspaper
sector, including Tribune Co., Knight Ridder and Journal Register.
Newspapers are experiencing serious circulation problems-many have been
caught printing thousands of extra copies daily to maintain ad rates
and then carrying them to the dump-but Olstein says those problems are
reflected in their stock prices.
William Fries, managing director at Thornburg
Investment Management, says that many value stocks have defied
expectations and displayed staying power over the last five years. In
contrast, some traditional growth companies have failed to produce
either persistent or cyclical earnings growth.
"Go back to October 2002, and cyclical industrials
and commodity companies were not participants in the recovery early
on," he says. "I don't think anyone was expecting energy companies to
do what they have. In the summer of 2002, Wall Street had assumed the
energy cycle had peaked. Now it looks like their earnings will continue
to grow fast."
Fries is also looking at companies with pricing
power or cost-cutting potential like Molson/Coor's, which was created
through a merger last year and will be increasing efficiency, for
example, when it shuts its Memphis, Tenn., brewery in early 2007. And
one bank that may prove conventional wisdom wrong and profit from
rising interest rates is Bank of New York.
At the end of the day, Fries thinks value, and
energy in particular, may have room left to run. "Energy is still not a
big part of the S&P 500," he says, "and supply is not easy to
produce."