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.

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