Those Bargain-Hunter Blues

The past year or so has been humbling for most value-fund managers. Many all but missed the commodity boom. Then, to add insult to injury, too many of them bet too heavily on financial stocks, which got pummeled in the credit maelstrom.

Of the two miscues, excessive exposure to bad banks and other troubled financial institutions is the more egregious. Most value investors describe preservation of capital as a vital part of their investment mandate. Risk to a value investor is not defined as volatility, but rather as the potential for permanent loss of capital. Yet, by investing in companies with disastrous risk-management systems, managers exposed their share-holders to unacceptable levels of danger.

Susan Byrne, manager of Gamco Westwood Equity fund, says many value investors were seduced by what on paper appeared to be bargains in financial stocks. The stocks offered high dividend yields and traded at low prices relative to earnings and book value (assets minus liabilities). "As a veteran, I've learned that the book value of financials is a moving target," she says. Byrne adds that because banks hold so many assets off their balance sheets, you can only infer how much a company is earning and how much exposure it has to problematic debt.

We examine the records of four value investors to glean lessons about the past year's debacle -- two who didn't exactly cover themselves in glory and two who did well at protecting their shareholders' money.

Humbling of a legend. Bill Miller's reversal of fortune is stunning. The manager of Legg Mason Value Trust fund (symbol LMVTX) famously beat Standard & Poor's 500-stock index for 15 straight years through 2006, the investment world's equivalent of Joe DiMaggio's 56-game hitting streak. But over the past year to September 8, Value lost 35%, 21 percentage points worse than the S&P 500. The performance of Miller-managed Legg Mason Opportunity fund ( LMOPX), a member of the Kiplinger 25, has been nearly as dreadful.

How does Miller explain himself? He wouldn't talk to us. But we did speak with him in March 2007. Recalling that conversation and reviewing Miller's portfolios, it's clear that he severely underestimated the severity of the gathering storm in the housing and credit markets. He thought oil was overvalued at about $60 a barrel. And he was far too bullish on the U.S. economy and stock market.

In that interview, Miller said he thought homebuilders were undervalued, so he was buying shares of Centex, Lennar, Pulte and Ryland Homes. He noted that stocks of builders were selling near book value, well below the norm of 1.6 times book value.

With the benefit of hindsight, we know that homebuilders' book values and stocks have collapsed since then. Miller made matters worse by holding large positions in mortgage and other financial stocks crushed by the housing-induced credit crisis -- companies such as AIG, Bear Stearns, Citigroup, Countrywide Financial and Freddie Mac.

If Miller's blind spot for energy had merely been a sin of omission -- failure to hold the stocks -- it wouldn't have been so bad. But he compounded his error (at least in Opportunity) by selling short two energy-related exchange-traded funds, a move that certainly hurt results in a period of sharply rising energy prices.

Hammered twice. Bill Nygren graciously agreed to talk about his funds' recent woes. Over the past three years, Oakmark Select fund ( OAKLX), a former Kiplinger 25 member that he co-manages, lost an annualized 4%, an average of six percentage points per year behind the S&P 500. Over the past year, it surrendered 21%.

Nygren divides his weak performance into two periods, through the first half of 2007 and from then on. His failure to invest in energy and other resources stocks mostly explains his weak performance during the first period. Like many value investors, Nygren generally shies away from those kinds of businesses because it's hard for them to distinguish themselves from rivals. "The determinant of success is the underlying price of commodities, over which they have absolutely no control," says Nygren.

He is far more chagrined about his fund's lousy results since the second half of 2007, when the roof caved in on housing and financial stocks. "As a value investor," he says, "you believe the stocks you invest in have much less risk of permanent loss of capital. This ended up not being true for several of my holdings."