Slow Economy Puts Value Investing to the Test

In his latest letter to shareholders of Legg Mason Capital Management, chief investment officer Bill Miller showed very little of the confidence he has been known for in the past.

Instead, he described standing with a group of other so-called value investors, who buy stocks cheaply in the hopes that their prices will rise to what they're worth. The money managers were doing something they hadn't done much over the years: commiserating over lost money and clients.

Then, according to Miller's account, value investing guru Warren E. Buffett approached them. Be happy if stock prices drop more, Buffett told the group, because buying opportunities will follow.

Miller wasn't buying it anymore, figuratively and literally. "As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more," he wrote in the July 27 letter.

For years, value investing was considered a tried-and-true method for succeeding in the stock market. In the past 15 years, large-capitalization value funds have had an average annualized return of 8.66 percent. For the same time period, large-cap growth funds, which favor companies that are growing rapidly, were up 8.03 percent, according to research firm Morningstar.

But the current economic crisis is testing the principles of value investing more than ever. The problem is that value investing is as much art as it is science. Money managers can look at tangible factors such as price-to-earnings or price-to-book ratios, but they also have to make assumptions about the quality of management and the effect of unforeseen events on stock prices. Value investors are now in the same predicament that growth fund managers were in when the tech bubble burst. Like the tech buyers did, many value investors underestimated how widespread and long-lasting the damage from the bubble, in this case housing, would be.

"Until the values can be defined, I think you're somewhat taking your life into your hands," said Peter Sorrentino, portfolio manager of the Huntington Real Strategies Fund in Columbus, Ohio. "A lot of value investors went into financials in the spring, and they're now getting killed."

Indeed, value investors gravitated toward financials because they got so cheap. After all, these investors reasoned, how much cheaper could they get? The answer, to their dismay, was much more, thanks to the troubles of mortgage giants Fannie Mae and Freddie Mac and the collapse of California-based bank IndyMac.

Last year was an unusually bad one for value investors. Large-cap value funds gained just 1.42 percent, while large-cap growth funds rose 13.35 percent. This year has not been much better, with some of the largest value funds showing double-digit negative year-to-date returns.

Take the Weitz Value Fund, run by veteran manager Wallace Weitz. Over a 15-year period, the fund has had an average annual return of 10.6 percent. But in the first six months of this year, it was down 18.9 percent. The Standard & Poor's 500-stock index dropped 11.9 percent in that time.

"A small portion of our losses will not be recovered -- we underestimated the speed and severity of credit deterioration and overestimated some companies' ability to cope with credit and liquidity problems," Weitz and his co-manager, Bradley P. Hinton, wrote to shareholders on July 16.

As of July 31, both growth and value funds were down, but growth funds were faring better, with a decline of 12.41 percent compared with a 13.83 percent loss for large-cap value funds.