Keith Fitz-Gerald

Five Keys to Value Investing Profits

by Keith Fitz-Gerald   11/20/08

Value funds have long been viewed as conservative investments. So why are they down an average of 42% during the past 12 months, and what's wrong with them?

No question, such numbers are scary, especially for large-cap value fund investors who have experienced that 42% drop. And the fact that some of the biggest names in value investing have taken such big beatings has to be especially disconcerting for investors who already have had their confidence badly shaken and their portfolios eviscerated.

Bill Miller's once-vaunted Legg Mason Value Trust Fund (LMVTX) has dropped 62%. Meanwhile, Marty Whitman's Third Avenue Value Fund (TAVFX) is down 50%. Even the Dodge & Cox Stock Fund (DODGX) fund has tumbled 49% year to date.

For many investors who viewed value funds as comparatively "safe," low-risk investments, this has to feel like a betrayal. And that's understandable, given that history has repeatedly shown the value discipline to be one of the strongest, most stable investment strategies available for navigating a bear market.

What's different this time?

Some managers -- like Legg Mason's Miller, as well as the Dodge & Cox team, for example -- simply underestimated the depth and severity of the challenges facing their investments. Adding insult to injury, they concentrated their investments in a relatively small number of core holdings they thought they "knew."

During good times, this concentration strategy can dramatically boost returns when stellar companies that had been trading at deep discounts subsequently rebound. But now, when times are tough, as is readily apparent, stockpiling money in one or two holdings like Lehman Bros. Holdings Inc. (LEHMQ) or Freddie Mac (FRE) can be devastating.

Others, like Whitman -- a gentleman who is often regarded as the "Dean of Value Investing" -- simply don't sell all that often, preferring to ride out market gyrations, which they view as a mere nuisance. So their performance is likely to suffer in line with the markets. But that's not necessarily a bad thing. In fact, Whitman, who is notorious for looking beyond what the public markets do, doesn't care that prices have fallen so low. He believes that undervalued companies will be taken over, liquidated or refinanced which, as he pointed out in an interview with Brian Zen last year, is "where you make your money."

While such strategies put value players on the losing side of the investment ledger for now, it will be a different ballgame when the markets turn, as they eventually will.

In fact, when we emerge from the other side of the current financial crisis -- which we will, and probably sooner than everybody realizes -- the deep-value choices available today will be some of the highest-performing investments for decades to come.

And for all the right reasons: Many of the underlying companies are still expecting solid business growth, diversified revenue streams and a clear path to higher earnings.

That means that one of the smartest moves a savvy investor can make today is to stick with the value-investing discipline. The historical record suggests that the best choices continue to be those companies with low or no debt, a high proportion of international revenue, and a history of solid dividend growth that pays us cold, hard cash for the ownership risks we take.

That is why there is nothing "wrong" with making value investing a key component of your investment strategy. Especially now.