Slow Economy Puts Value Investing to the Test

By Nancy Trejos
Washington Post Staff Writer
Sunday, August 10, 2008

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.

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.

Croft also likes General Cable, a Kentucky-based producer of copper, aluminum and fiber-optic wire and cable products in the energy and communications market. He said he considers it a good investment because it has had earnings growth and it sells its products not only in the United States but also abroad, where some markets have been faring better.

Bruce Berkowitz's Fairholme Fund, meanwhile, picked up shares of health-care stocks at what it considered reasonable or dirt-cheap prices. Pfizer became the fund's second-largest holding, and WellPoint, provider of health-maintenance organizations and other forms of medical insurance, broke into the top 10. Both have plummeted since May 31. Not to worry, Berkowitz and the other managers wrote in a July 24 letter to shareholders.

"These fundamentally sound businesses have become fallen angels, as slowing growth, rising costs, and election-year politics stoke investor fear," they said. "Still, these are companies with essential products and services and large free cash flows relative to purchase prices. We expect them to rise again."

Even hard-core value investors acknowledge that some of their peers were too quick to jump on the financials bandwagon, which ended up being a sinking ship because of a spike in foreclosures and a tightening of credit.

"I think a lot of the managers didn't expect the housing situation to get as nasty as it has," Lowe said.

Such was Miller's fate. He made his reputation by outperforming the S&P 500 for 15 straight years but chose to invest heavily in Bear Stearns and Fannie Mae, two of the biggest losers in the credit crisis. The fund has dropped more than 30 percent in the past year.

Weitz also got hurt by financials, but he is not giving up completely on the sector. He is sticking with Redwood Trust, a real estate investment trust active in the residential mortgage market.

"They have been preparing for this credit crisis for years and should be able to benefit from distressed sales of mortgage assets by banks and hedge funds," Weitz and Hinton wrote to shareholders.

Weitz's fund also has a stake in American Express, despite investors' concerns with the company's decision a few years ago to depart from its traditional model and provide revolving credit to some customers. While acknowledging that the company is not immune to the credit crisis, Weitz said he believes in its core earnings power, thanks in part to the fact that it earns transaction fees.

Buffett has had some recent bumps, too. His Berkshire Hathaway reported an 8 percent decline in second-quarter profit because it collected fewer insurance premiums and recorded $1 billion in unrealized derivative losses. The company's stock is down 17 percent since the beginning of the year.

Despite some risky picks, Berkowitz's Fairholme Fund is still beating the S&P 500. For the five years ended June 30, the fund has had an annualized return of 15.24 percent, compared with 7.58 percent for the S&P 500. For the year ended June 30, it lost 3.47 percent, while the S&P 500 lost 13.12 percent. And for the first six months of this year, the fund was down 5.9 percent on a total return basis.

"Over the 8 1/2 years since the Fund's inception, we have lived by the belief that you should be fearful where others are greedy and to be greedy where others are fearful. We continue to ignore the crowd," wrote Fairholme Capital Management in a July 24 letter to shareholders and directors.

The managers have also invested heavily in housing-related industries. Among the fund's biggest investments are the Dish Network, Mohawk Industries and Sears Holdings. Those companies, the managers wrote, "continue to generate much cash while awaiting more stable times, and all have rational and opportunistic owner/managers at the helm. Investing is often an exercise in patience, and the drag from the housing bust is giving our patience a good workout."

Staff writer David Cho contributed to this report.