Value investing is supposed to get ugly

One of the tenets of value investing is there will be times when it’s going to get ugly. Problem is, for a lot of established value firms, things have never looked uglier — leading some advisors to question the wisdom of the strategy. But fund analysts say there is merit to what value firms are doing right now and investors should wait before they write off their value holdings.

In his latest research bulletin, independent fund analyst Dan Hallett writes that investors need to be more patient with some of the value firms getting beat up right now, which include traditional advisor-favourite brands like Brandes Investment Partners, Saxon Mutual Funds and the Trimark fund family.

“We can draw on our experience from counselling many frustrated advisors in the late 1990s. Then, as now, many value managers with strong track records could seemingly do nothing right. Whatever the market valued highly, these managers saw as too frothy for their bargain-hunting disciplines. What they saw as cheap, they purchased, only to see it go lower or flat-line. Sound familiar?” Hallett says. “Similar to the late 1990s, the way to benefit from their strong subsequent returns was to buy them when they were deeply out of favour — not after a strong five-year run.”

Hallett says the problem today is in the last bear market, which came after the tech bubble burst, many value firms continued to do well. In light of this, Hallett suspects there are a lot of value-convert advisors who are under the impression that value funds are somehow not correlated to market conditions.

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“Even the best managers hit rough patches that can last three to five years. When value managers glided through the last bear market smelling like roses, many investors and advisors found the ‘value investing religion,'” he says. “The approach makes sense, and the returns were fabulous, so they jumped on the bandwagon. A number of people did that without an appreciation of the history of value investing — in the early ’70s and early ’80s, there were some pretty awful periods.”

Hallett says the majority of funds on his recommended list have a “value tilt” to them, but he believes advisors and clients alike have to look at the track record of value investors to get a sense of what makes a successful value mandate.

“That key is selecting good managers. Not everyone that calls themselves value managers is really true to that label or good at what they do,” he says. “I would say most of the managers on my list have a value tilt — not all of them are getting beaten up, but lots of them are.”

However, one of the things shaking investor confidence in the strategy is some of the most established value brands are having unprecedented difficulty. Probably most noticeable is Brandes Investment Partners. Brandes as a firm has only been in Canada for a few years, but its founder, legendary value investor Charles Brandes, has a three-decade track record of tremendous success.

“I have received a lot of calls from advisors about Brandes because [Brandes has] experienced their worst performance in their history over the past year or year or two,” Hallett says. “It really comes down to this — make a firm decision. Do you think Brandes and their success over the last 30 years has been a fluke, or has something really changed?”

Of course, since past performance is not a tell-all indicator of future success, there is no concrete answer to this, but fund analyst Jordan Benincasa with Morningstar Canada believes Brandes’ strict adherence to Benjamin Graham and David Dodd’s value investing philosophy should pan out.

The frustrating thing for investors is a firm like Brandes lets valuations dictate the buys, so it is going to buy value traps, but the point of the strategy is to get enough names in a diversified portfolio so the winners outperform the losers. Benincasa says this has worked in the past over the long term.

“It’s a great time for value managers to buy companies that have been sold off irrationally and over the long term should play out well,” he says. “That’s the point — you don’t know which companies are going to do well on an individual basis. If you pick enough of them overall, you should perform well over the long term.”

Benincasa also notes that Brandes’ stock picks aren’t as bad as they currently look to Canadian investors because of the fact that the company doesn’t hedge its currency. This is a problem that has also plagued the Canadian offering of Legg Mason’s flagship Legg Mason Value Trust, managed by Bill Miller. The fund is available to Canadian investors as the CI Value Trust.

Miller, known as the “man who beat the S&P” for his unprecedented 15-year streak of outperforming the S&P 500 benchmark, is also having one of his worst years on record.

“If you look at Bill Miller’s portfolio, 23% is in financials, and the S&P is about 17%, so he has been moderately overweight in the financial sector,” Benincasa says. “Financials underperformed significantly in 2007. The CI Value Trust lost 21% in 2007, and the S&P 500 lost 10%. That’s in Canadian dollars.”

Its one-year returns are even worse. Miller has opted to stay invested in financials and many stocks that are heavily reliant on the depressed U.S. homebuilding industry, such as Sears. As a result, the Legg Mason Value Trust is down 24%. The CI Value Trust is down 33% because of the effects of the Canadian dollar.

Yet, true to his discipline, Miller is sticking to his picks — aside from a recent admission that holding Bear Stearns was a mistake — meaning his investors are likely in for a bit of a ride before things have a chance to get better.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(04/08/08)

Mark Noble