Value investing basks in a new
light
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Value stocks are the low-priced part of the market, the
companies too far out of the fashion cycle to be
appreciated—like the old dockside warehouses that are
shined up to become hip, luxury condos, or the one-time
math nerd who leaves high school with a calculator on his
belt, and comes to the reunion with a billion-dollar
trading algorithm and a Bentley. To be successful at the
value style, investors need a sense for what the market
will cherish in the future, and when they will be looking
for it.
After the tech "bubble," value stocks strongly
led the US market: 7.8% per year for the Russell 1000 Value
index, versus just 1.7% for its Growth counterpart. Lately,
however, the energy has equalized, so that, for the 12
months ended March 2005, the annualized performance of
lower-priced value and higher-priced growth was nearly
equal: 13.30% versus 13.15%, respectively, for the Russell
1000 Value and Growth indices. More important, the
valuation levels of the two groups now stand close to their
25-year averages: Expecting further big gains for value
stocks would entail rich valuations—the antithesis of value
investing.
"Historically, they've been businesses that follow
industrial or interest rate cycles—the rusty and greasy
basic sectors, as well as financial companies," says Tim
Keefe, senior vice president and value portfolio manager at
Sovereign Asset Management, which runs institutional
accounts and mutual funds for John Hancock Life Insurance
Co. "However, what really create value situations," he
notes, "are businesses that are prone to mistakes and
misunderstandings."
"There's an interesting dilemma. Health care,
telecommunications, and media: These are the former growth
areas that have been neglected for five years, and are in
the value category today," notes Thomas McKissick,
portfolio manager for value equities at the $125 billion
TCW Group in Los Angeles.
"Yet, there's still a mindset that there's a two-year
cycle between growth and value," McKissick adds, "and many
people are getting out too soon. What has been labeled in
the past as value is where today's growth is: basic
materials, energy, and industrial companies. That's
confusing people about where the cycle is headed."
The source of the new-old value dilemma, McKissick
believes, is the broad-based growth in emerging economies,
taking the lead from the developed nations. "It's being
driven by growth all over the world," McKissick says. "From
China and Eastern Europe, four billion market participants
have been let loose in the world economy. The demand side
is stunning, and the supply side has some real problems;
you just can't flip a switch and bring enough capacity on."
The world's requirements for energy, steel, and cement will
not be satisfied for several decades, he says. "Despite the
runs the stocks have had, they are still some of the
cheapest in the market."
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Start Worrying
By and large, value investors want to buy existing
businesses on the cheap, based on the historical numbers,
but today's market is no yard sale. Over the five years
ended March 2006, notes Kevin Johnson, portfolio manager at
value investors Aronson+Johnson+Ortiz in Philadelphia, the
Russell 1000 Growth index underperformed the full Russell
1000 by 3.1% per year, while the value group outperformed
by 3.1% annually—a 6% spread in return, for five years, for
the biggest 1,000 names in the US market.
"[After the long run,] pricing of value stocks today is
not out of line; it's at the center of the historical
range," Johnson notes. The Russell 1000 Value index is
trading at 16.7 times trailing 12-month earnings, versus a
25-year average of 15.4 times, and the relationship between
the price/earnings ratios of the growth and value groups
stood at 0.69 at the end of 2005, versus a median of 0.67
over the last 25 years.
More important than the level of valuation, Johnson
says, is what is behind the numbers—with p/e ratios in the
middle of their valuation ranges, so neither group is
showing widespread opportunities. When the growth style
reigned at the last cycle peak in 2000, he recalls, the
markets were driven by the vapor of paradigm shifts, the
so-called "New Economy," and the growth investors' taunt,
"You just don't get it." Since 2001, Johnson explains, "The
value stocks have performed better because they've put up
better earnings."
"It's worrisome that there's a convergence between the
valuation of growth and value stocks," says Timothy Keefe
of Sovereign. "Value guys like to take comfort that our
stocks are anticipating fairly negative events. However,
many value stocks are trading at prices that look 'through
the valley' to the peak of the next cycle, and there's not
much spread between them and growth stocks. We've got a
smaller margin for error if things go wrong."
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