Slow Economy Puts Value Investing to the Test

What's more, investors are now abandoning some value funds. Baltimore-based Legg Mason, for one, has lost billions of dollars from investor withdrawals as of June 30.

"I think we've seen the peak of value investing, and we'll probably see a peak in growth for two or three years until value investing works again," said Mark Coffelt, president and chief investment officer of Empiric Funds in Austin.

Value investors defend their strategy. Sure, the last 18 months have been grueling, but value investing is about long-term, not short-term, gains, they argue. A true value investor buys a stock at less than the company's "intrinsic value," which is measured in ways both tangible and intangible. Thus, the theory goes, a stock's price is likely to go up, but even if it dips further, it's cheap enough that it does not have a long way to fall.

"The number one most important thing is to be calm and patient," said Mohnish Pabrai, managing partner of Pabrai Investment Funds in Irvine, Calif., who has preached the philosophy for years.

Sometimes though, value investors can fall into what is known as a value trap. That happens when a stock price falls, and falls and falls.

Most value investors brush off that concern by saying you will eventually recoup your losses if you are willing to wait. But, said Sorrentino, "I would caution that you could go broke waiting for these investments to turn around. You can be right in the long run and go out of business in the short run."

But, for the most part, many value investors are actually relishing this moment.

"I really think it's sort of a best-case environment for value investors," said Atticus Lowe, chief investment officer of West Coast Asset Management in Ventura, Calif.

Value investing requires quite a bit of analysis. These investors -- adhering to a conservative approach -- search for a "margin of safety." They might look at net cash or tangible assets on balance sheets. They look at cash flow and whether it is likely to grow or shrink. What are the risks for the company? How aligned are management's interests with those of shareholders? What are potential catalysts that could trigger changes in stock prices? For instance, if it's a pharmaceutical company, is there a product in late-stage development that could affect the stock's performance?

"Put those things together and come up with a framework for intrinsic value," Lowe said.

Michael Breen, a senior analyst at Morningstar, generally likes value investing but warns that no two value investors are the same. "There's a whole range of styles and you need to line up with the type you're comfortable with," Breen said.

Kent Croft, chief investment officer of the Croft Funds and manager of the Croft Value Fund, said he considers himself a contrarian. One of his picks is the forest-products company Weyerhaeuser. Although it is a bit exposed to risk because of its real estate holdings, it also has a good amount of timberlands, he said. "It's not being recognized in the marketplace for long-term value," he said.